House of Commons Treasury Committee

Bank of England November 2011 Inflation Report

Oral and written evidence

28 November 2011 Sir Mervyn King, Governor, Paul Fisher, Executive Director, Markets, Dr Ben Broadbent, and Dr Martin Weale CBE, external members of the Monetary Policy Committee, Bank of England

Ordered by the House of Commons to be printed 28 November 2011

HC 1675 Published on 13 January 2012 by authority of the House of Commons London: The Stationery Office Limited £0.00

The Treasury Committee

The Treasury Committee is appointed by the House of Commons to examine the expenditure, administration, and policy of HM Treasury, HM Revenue and Customs and associated public bodies.

Current membership Mr Andrew Tyrie MP (Conservative, Chichester) (Chairman) Michael Fallon MP (Conservative, Sevenoaks) Mark Garnier MP (Conservative, Wyre Forest) Stewart Hosie MP (Scottish National Party, Dundee East) Andrea Leadsom MP (Conservative, South Northamptonshire) Mr Andy Love MP (Labour, Edmonton) John Mann MP (Labour, Bassetlaw) Pat Mcfadden (Labour, Wolverhampton South East) Mr George Mudie MP (Labour, Leeds East) Jesse Norman MP (Conservative, Hereford and South Herefordshire) Teresa Pearce (Labour, Erith and Thamesmead) David Ruffley MP, (Conservative, Bury St Edmunds) John Thurso MP (Liberal Democrat, Caithness, Sutherland, and Easter Ross)

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List of witnesses

Monday 28 November 2011 Page

Sir Mervyn King, Governor, Paul Fisher, Executive Director, Markets, Dr Ben Broadbent, and Dr Martin Weale CBE, external members of the Monetary Policy Committee, Bank of England Ev 1

List of written evidence

1 Report to the Treasury Committee from Sir Mervyn King, Governor of the Bank of England Ev 19 2 Report to the Treasury Committee from Paul Fisher, Executive Director, Markets, Bank of England Ev 20 3 Report to the Treasury Committee from Dr Martin Weale CBE , External Member, Monetary Policy Committee, Bank of England Ev 21 4 Letter from Sir Mervyn King, Governor of the Bank of England Ev 22

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Treasury Committee: Evidence Ev 1

Oral evidence

Taken before the Treasury Committee on Monday 28 November 2011

Members present: Mr Andrew Tyrie (Chair)

Michael Fallon Mr George Mudie Mark Garnier Jesse Norman Stewart Hosie Teresa Pearce Andrea Leadsom Mr David Ruffley Mr Andrew Love John Thurso Mr Pat McFadden ______

Examination of Witnesses

Witnesses: Sir Mervyn King, Governor, Bank of England, Paul Fisher, Executive Director, Markets, Bank of England, Dr Ben Broadbent, and Dr Martin Weale CBE, external members of the Monetary Policy Committee, Bank of England, gave evidence.

Q1 Chair: Good afternoon, Governor. Good Sir Mervyn King: Beyond the one-year horizon, we afternoon, other members of the MPC. have not made significant changes to our growth rates Sir Mervyn King: Good afternoon, Chairman. in the forecast in the second and third years. They are largely unchanged. So we have a period of a soft patch Q2 Chair: Can I begin by asking you about growth over the first year, with weaker growth, but then we in the eurozone? Everyone is now suggesting that expect some bounce-back in the second and third growth is well down, and is going to remain well years, as before. down on what it would otherwise be, both in terms of out-turn and prediction. What proportion of that do Q6 Chair: So you are implying a resolution to the you estimate is caused by the eurozone crisis? eurozone crisis, somehow? Sir Mervyn King: If you go back to the projections Sir Mervyn King: No, we don’t know. Indeed, we we made in August, obviously we do not make a point were very careful to say that— forecast; it is a fan chart. The whole of that distribution has been revised down— Q7 Chair: I have seen that in the text. Sir Mervyn King: The extreme events associated with Q3 Chair: Looking at the central rate. developments in the euro area are simply not in the Sir Mervyn King: For growth over the next 12 fan chart; it is impossible to quantify them. months: in the first year of our forecast, growth has been revised down across the board by over 1 Q8 Chair: In making that assessment yourself, are percentage point. That is a very big reduction. I would you an optimist or a pessimist that the eurozone is say that the bulk of that can be attributed, directly or going to get through this crisis without fragmentation? indirectly, to a changed perception about Sir Mervyn King: Well, you have to define what circumstances in the euro area: directly, through lower optimism and pessimism mean in that context. exports from the UK to the euro area; and indirectly, through lower asset prices and lower wealth—share Q9 Chair: I have described it as fragmentation with prices have fallen and credit spreads are also higher, that being on the pessimistic side. because the funding costs of our banks, as well as Sir Mervyn King: That is something which we have those in the euro area, have risen. If you put all those not made a judgment on. It will depend on the politics things together, the bulk of the downward revision can in the euro area, which you are better placed to decide be attributed ultimately to news since August about than we are. what is happening in the euro area. There are some other sources of news—clearly there are signs of Q10 Chair: Maybe I should ask an economic slowing in the world economy as a whole—but the question to get the ball firmly back in your court. Do bulk of it is the euro area. you think that the Greek economy can recover at current exchange rates? Q4 Chair: When you say “the bulk”, are you talking Sir Mervyn King: Let me not base it on one economy. about 51% or 99%? Let me make a more general statement, which is that Sir Mervyn King: I am not going to give a precise underlying this problem is a crisis of current account percentage, but it is well over 51%—it is the bulk imbalances. Germany and the Netherlands have very of it. large trade surpluses. Many economies in the south, including Greece, have large trade deficits. The Q5 Chair: And looking forward? question is: how can they get back to a point when cobber Pack: U PL: COE1 [E] Processed: [03-01-2012 12:39] Job: 017636 Unit: PG01 Source: /MILES/PKU/INPUT/017636/017636_o001_th_TC 28 11 11 Corrected.xml

Ev 2 Treasury Committee: Evidence

28 November 2011 Sir Mervyn King, Paul Fisher, Dr Ben Broadbent and Dr Martin Weale CBE these can be financed and, ultimately, the debt inflation, and the stability of the banking system at serviced? those times. What we have seen is that the private sector, since the Sir Mervyn King: As I said, there are some painful summer, has indicated pretty clearly that it does not adjustments to be made whatever the scenario as the want to finance these current account deficits. That euro crisis develops. Therefore, the fact that very large has left Governments to finance the deficits— potential credit losses have been built up prior to the primarily the euro area Governments. Given the scale crisis beginning means that there will have to be a of the debts which have been built up to the rest of rebalancing between both creditors and debtors. The the world and some of the periphery countries, it is idea that only debtors will pay the burden of this is very hard to see how just making further loans to mistaken; creditors will have to accept some of the those countries will actually resolve the problem. burden, too. How that is shared, how it plays out, how During the transition period in which they regain serious it is, is almost impossible to know. competitiveness, which is clearly crucial to having any sustainable path for those countries—they have to Q15 Jesse Norman: Would it be better for the UK find a way of regaining competitiveness—those for a euro-area default to be inside the euro rather current account deficits will need to be funded, I than outside? suspect, largely by transfers rather than by loans. Sir Mervyn King: I do not want to make any What markets are looking for is a clear signal from statements to that effect, no. All I will say generally other Governments in the euro area that they are is that there are these painful adjustments to be made. willing to provide the transfers. This is a very old It would be much better if they were made in an problem of current account surpluses and deficits. It orderly rather than a disorderly way. is not a problem to do with fancy financial instruments or modern economics; this is as old as the hills. Q16 Jesse Norman: We are already seeing deleveraging across Europe in the commercial banks. Q11 Chair: In fixed-rate systems. How safe are the UK banks from the impact of that Sir Mervyn King: Yes. deleveraging on the British financial system and the potential real shock to further confidence? Q12 Jesse Norman: This is a question for you, Sir Mervyn King: The British banks are clearly much Governor, but by all means share it among the others better capitalised than they were in 2007–08. Clearly, if you like—it is really persisting on the issue of the they are also better capitalised than many banks on eurozone. In the worst-case scenario, what would be the continent and in the euro area. When the European the economic impact of a euro-area country default on Banking Association published its estimates of the the UK economy? amount of capital that the European banks needed to Sir Mervyn King: It is very hard to give a worst-case obtain over the next six months, it allocated the scenario from that. Many things could happen. An numbers by country, and argued that many countries awful lot will depend on the politics of it. I am not in the euro area required significant amounts of capital sure whether it is terribly sensible to try to pretend to to be injected into their banks. It thought the quantify the worst-case scenario. appropriate number for the UK was zero, so it did not What I would say more generally is that we are facing recommend that more capital be injected into the UK a situation in which some painful adjustments need to banking system. be made, both for creditors and debtor countries. Clearly, other things being equal, the more capital a Those adjustments will be necessary irrespective of banking system has, the better able it is to withstand how the euro-area crisis plays out, so there is no easy shocks that come. None of us can really know the way out of this. Maybe others would like to comment, scale of shocks that might come from the euro area, but I do not see much point in trying to speculate on and no banking system can withstand shocks that are the worst case. I suspect it is always possible to find sufficiently large, so there is certainly no room for things, as they pan out, that are even worse than you complacency. could imagine. Q17 Jesse Norman: The report makes it clear that Q13 Jesse Norman: Quite so. In your scenario the UK banking system has become less safe over the planning or modelling, do you look at the difference last quarter, if you judge by CDS spokesmen. between a default inside and outside the eurozone? Sir Mervyn King: Yes, over the last quarter, all banks Sir Mervyn King: As we said in the report, the more have become less safe, because our banking system is extreme events associated with developments in the exposed to the euro area—there is no question about euro area—I think sovereign defaults come under that it. The countries that matter, primarily, for UK banks category—are not things that we have tried to are Spain and Italy, and exposure is not primarily to quantify, because they will depend, critically, on sovereign debt; exposure is to other banks in the euro market responses to them, which will ultimately area and also directly to the real economy in those depend on whether people believe that the solution countries. that is put forward is politically sustainable. Q18 Jesse Norman: But the market for bank funding Q14 Jesse Norman: I guess I was asking about has tightened considerably. There has been no term scenarios that have not necessarily been taken to the debt from any bank over the past three months. Bank full level of quantification. I am thinking about the funding has shortened in the money market possible implications for growth, broadly conceived, significantly. 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Treasury Committee: Evidence Ev 3

28 November 2011 Sir Mervyn King, Paul Fisher, Dr Ben Broadbent and Dr Martin Weale CBE

Sir Mervyn King: It is causing a great deal of concern. spare capacity and subdued wage growth would result I think it is causing a great deal of concern to policy in inflation moving below target. Clearly, that depends makers around the world. I regularly discuss it with on the outlook for spare capacity, a very difficult thing my opposite numbers. to achieve. According to the inflation report, there are some misgivings about whether the Bank has got that Q19 Chair: Just to be clear, you have said that things correct. The business surveys do seem to suggest that could get even worse than we can possibly imagine there is not as much spare capacity. Why are you so on the downside. Could they get better than we could confident that the Bank is right about the measure of possibly imagine? spare capacity in the economy? Sir Mervyn King: Absolutely, they certainly could. Sir Mervyn King: Well, we are not. We are very The point I’m making is not that they will be worse. uncertain about how much spare capacity there is. You Far from it, but I don’t actually think there is a great can look at it from two different viewpoints. One is deal of point pretending that we can quantify or even that clearly there is spare capacity in the labour describe accurately how things will play out. If you market; we see that with the higher levels of go back to 2007, I remember that we had regular unemployment. How much spare capacity there is in discussions at the IMF about how the imbalances firms is harder to judge. It may be that there is a very would unwind in the world economy. Almost all our large amount of labour hoarding going on within firms discussions concluded that they were likely to unwind at present, which would indicate that in total there was with a significant fall of the US dollar. We did not a great deal of spare capacity. On the other hand, the conclude they were likely to unwind with an evident surveys do not support the view that there is a collapse of the banking system. particularly large amount of spare capacity. There are many things that could happen, if It is very difficult to judge. In the end, it comes down developments in the euro area get worse. I honestly in part to a view about whether one thinks that the do not think it makes much sense to pretend that we underlying growth of potential output—productivity know precisely how this will play out. What we have growth—over the past four years has continued at the to do is be ready and prepared, with contingency usual average historical rate, which is about 2% a plans, and to ensure as far as possible that our banking year. That has been very stable for a long time—50 system is as robust as possible to withstand whatever years or more. Or, whether that has, in these shocks come from the euro area, of whichever sort circumstances, fallen back and, for some reason that or origin. is not entirely easy to quantify, that productive potential has not risen in the past four years in the Q20 Chair: I think you are inadvertently quoting way that we would normally expect it to. If that were “Star Wars” with your apocalyptic downside risk the case, that would be consistent with there being scenario. I don’t know in which role you are casting much less spare capacity than one might think, given yourself. the low growth rate of output over the past four years. Sir Mervyn King: I am not an expert on “Star Wars”; There is enormous uncertainty. My colleagues will not as much as you are. have other, different views. For me, there is enormous uncertainty. Q21 Chair: I had to get some clearance from my Clerk to be sure that remark was right. Jesse, you Q25 Mr Love: I will come to them in a minute, but wanted to come back with a quick question. surely that then requires the Bank to do more research into both the output gap and this mysterious reduction Q22 Jesse Norman: Just to be clear, it cannot be in the improvement in productivity. Are you doing helpful, can it, for there to be further delay in that? measures taken to resolve the euro crisis? It must be worsening outcomes when they eventually occur. Sir Mervyn King: We are indeed. Sir Mervyn King: That is certainly true. Q26 Mr Love: Much depends on this being the case, Q23 Jesse Norman: As it were, the earlier the better in terms of your strategy. from your and the Bank’s point of view. Sir Mervyn King: It does, and we are doing it, but I Sir Mervyn King: Yes, but it is important that they put enormous weight here on the information from our are convincing answers. It is all very easy for those regional agents, who, between them, talk to more than of us not in the euro area to criticise countries that 8,000 companies across the country. We have a chance are. What they are trying to do is put together an to supplement that with our own visits, so we can ask agreement between separate sovereign nations about a questions ourselves, but I think that this is a case way forward that is going to change radically the where just going directly to what is happening in nature of their union. I don’t think any of us would be companies may help us to understand what is particularly enthusiastic to jump from one position to happening, but it is a puzzle. These are unprecedented a radically different one in two or three days, but the circumstances, so just to look at past data as a means market pressure is clearly there. of guessing what has happened is not terribly helpful in these circumstances, but we are trying our best to Q24 Mr Love: Governor, in your statement or report find out what is going on. to the Treasury Committee you said that there were two key risks to the inflation outlook. On the one Q27 Mr Love: But the business surveys seem to be hand, there was the risk that a persistent marginal very clear. I do not know which one of you to ask— cobber Pack: U PL: COE1 [E] Processed: [03-01-2012 12:39] Job: 017636 Unit: PG01 Source: /MILES/PKU/INPUT/017636/017636_o001_th_TC 28 11 11 Corrected.xml

Ev 4 Treasury Committee: Evidence

28 November 2011 Sir Mervyn King, Paul Fisher, Dr Ben Broadbent and Dr Martin Weale CBE or other Members. Are there more concerns about Sir Mervyn King: We do not see it as an immediate whether the level of the output gap is—? concern, and I think that it is fair to say that wage Chair: I think that Dr Broadbent wanted to come in. growth has been remarkably subdued for a Dr Broadbent: Do I? If you are asking me a question considerable period of time. There is no doubt that as Chairman, I will be happy to answer it. the experience of high unemployment continues, one Chair: That was the impression I got, but if you do of the problems about which all of us should be not want to, now is the time to withdraw, but I think concerned is the rise in the underlying structural level you had something to say. of unemployment. It is important that the Mr Love: So I will ask Dr Broadbent. Government, as far as possible, takes measures to Dr Broadbent: Thank you very much. Most of the reduce that rise in structural unemployment, such that, time that I have been on the Committee, which has when demand recovers, employment can pick up. been only six months, has been spent talking about What is clearly going on at present, I think, is a either the euro area or precisely the question you rebalancing of the economy, not just in terms of asked. It is not easy either to answer what the level of demand and output, but in terms of employment. We spare capacity is now—in fact, it is even harder to see some sectors of the economy shedding answer where it is going over the future, if we are not employment and other employers hiring. One of the confident about the growth rate of productivity. things that struck us over the past year was that, well, One thing I would point out is that, as the Governor employers are hiring labour, which is not normally said, there are clear signs that there is a wide margin what you would associate with a very large level of of spare capacity in the labour market, and that is spare capacity. That is one reason why this has been probably more than half the output gap. The other such a difficult question to answer. The starting point thing is that it is not actually the case across all for us is to say that total output is probably around business surveys that they say that there is not much 10% below where it would have been had the spare capacity. It is mainly the case in manufacturing. economy gone on growing at its completely Those surveys say that capacity use is around average. acceptable pre-crisis trend. That is a massive shortfall In services—a sector for which I would argue it is of output relative to where you would have expected harder to gauge what spare capacity actually means— it to have been. Not all of that seems to be accounted there is some indication of spare capacity, but we are for by observable spare capacity, but, equally, it is undertaking quite a bit of work to try to understand very hard to see why you would expect the productive what has gone on. I would say that it is not wholly potential of the economy simply to stop growing at exceptional to see slow productivity growth after all. financial crises, but I think that even relative to other So that is the fundamental question that is driving our severe banking crises, the experience of the UK over thoughts about the labour market. So far we see, and the past three or four years is exceptional, so there is I think we would expect to see it continue, subdued clearly a puzzle. wage growth. One of the factors that might have led Dr Weale: May I add some observations to that, wages to rise over the past year and that we were please? I think that one has to be careful about how concerned about is the squeeze on real take-home pay. one interprets the surveys; for example, it is not clear There has been a very sharp squeeze on real take- to me how a boarded-up shop fills in a survey to say home pay, but next year, although that squeeze will that it is a boarded-up shop that could reopen. Another not be reversed, there won’t be a further squeeze, possibility, which, based on the businesses I visit and which is one of the good pieces of news in the talk to, I am sure is true to a greater or lesser extent, outlook. That should help to diminish the upward is that people are having to work much harder, at least pressure from what is known as real wage resistance. in some activities, than they did before the crisis to do the same amount of business. If you are selling Q30 Mr Love: The other risk that you mentioned in things as a business, and you have to go out to look your report to the Committee was inflation expectation for customers, that may be quite a lot more work than rising. We have seen a consistent period of higher it used to be, and in that sense, productivity has indeed inflation than originally expected—it is 5% now, and stagnated. Of course, if the economy were more we were at 5.2%. How do you think that will filter buoyant, people might find that they could get on with through in current circumstances to expectations and what they wanted to be doing, which is providing demand for higher wage settlements and to price services and not just selling them. increases? Sir Mervyn King: It is too soon to be completely Q28 Mr Love: Let me go on to the second part of confident about it, but I think we can draw what you said about subdued wage growth. That is considerable comfort from the fact that all the certainly the case at present. indicators that you would normally look at to see signs Sir Mervyn King: It is indeed. of higher inflation expectations—be they nominal wage growth, expectations of inflation in financial Q29 Mr Love: But the level of unemployment and markets on yields, gilts and other assets, or, indeed, long-term unemployment is increasing. There are a lot direct survey measures of long-term inflation of young people out there who have never been in the expectations—fail to show any significant pick-up. market. As well as the usual attempts to catch up that Clearly there has been a rise in short-term inflation may happen in future, there may be labour market expectations, but not only is that unsurprising, it is constraints that will lead to wage inflation. Aren’t you what you would expect because our own forecast has at all concerned about that? gone up and inflation has been high recently. 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Treasury Committee: Evidence Ev 5

28 November 2011 Sir Mervyn King, Paul Fisher, Dr Ben Broadbent and Dr Martin Weale CBE that now people are beginning to realise that the The point I would make is that over the last year or factors that led inflation to rise over the past year or so, the factors that have been largely responsible for so are diminishing. Although there is no certainty slower growth than was expected have been an about the future, I do not think it would be in most unexpectedly strong squeeze on real take-home pay. people’s central view that they expect a repetition of We did not expect a year ago that energy prices the rise in energy and food prices that we have seen worldwide would rise by 35%. There was a very in the past year, of the increase in VAT or of the sharp significant squeeze on real take-home pay. I do not fall in sterling that we saw over three years ago. think it would be sensible to expect that to be repeated next year. Who knows what will happen? We cannot Q31 Mr Love: It would be unkind of this Committee be certain, but I think the balance of risks is not to remind the Bank of previous inflation forecasts and towards a further squeeze on real take-home pay. how, in the recent past, inflation has always been Consumption has been squeezed a long way already. higher than expected. Does that cause you some It is 6% down on its peak level at the end of 2007. concern? Is your credibility at stake? That is a pretty dramatic fall in household Sir Mervyn King: No, it would not be unkind at all. consumption. At some point, you would expect that it It is a question that we look at and think about. The will have reached as low a level as households feel point I made to the Chairman earlier is that our that they need to go in order to be able to start to see forecasts are not point forecasts. The statement that a small growth in consumption in the future. Total we forecast inflation next year to be 2.8%, or whatever output in the economy is 4% below its peak, so number you want to choose, is not coherent. The consumption has fallen even further. The concerns forecast is a probability distribution; it is a statement that we have are less about domestic demand, because about the balance of risks. That is the only sense in we expected that to be weak. We had expected that which a forecast can be used. We have been able to exports would pick up a good deal of the balance in explain why inflation was above the central view in terms of some stimulation in growth. We have seen our forecast by reference to the unexpected events that that over the last year or so, but going forward I think occurred and the events that other people did not we are concerned that problems in the euro area, expect to occur that were not in their central view unless quickly resolved, could lead to weaker outlooks either, mainly the rise in energy and food prices across for exports than we had expected earlier in the year, the world and the increase in VAT. and that is one reason why we have downgraded the I think we can account for past movements in forecast for the coming year. inflation. All I would say at present—I think people do understand when we make the point to them—is Q33 Mr McFadden: Do you then disagree with the that a reasonable person would not have in their OECD when they predict not flat, but actually central view another 35% rise in energy prices this contracting output over the next two quarters? year plus sharp increases in food prices. They would Sir Mervyn King: I have not seen the OECD not have another rise in VAT and would not expect a document I am afraid. It came out this morning. further 25% fall in sterling. If these rather extreme Mr McFadden: I find that hard to believe. events were not to occur, you would have to have a Sir Mervyn King: All I would say is that there is a very rapid and significant upward surge of domestic balance of risks. We do not predict a number— inflationary pressure to prevent inflation from coming whether it is up or down. We said in our report that down. As you point out, with unemployment high and the balance of risks was on the downside from our now beginning to rise, this does not seem to be a set central projection. The central projection was for of circumstances in which domestically generated broadly flat output, but thereafter output beginning to inflation is likely to pick up. pick up. What is important is not whether growth in the next six months is plus 0.2 or minus 0.2, but Q32 Mr McFadden: I would like to ask you, Sir whether we appear to have a framework in which it is Mervyn, about the outlook for economic growth going plausible that growth will pick up. That is not easy to forward. Tomorrow, we are going to have the autumn put in place when the euro area finds it very difficult statement, and every time we have had a Government to have any plan for them that makes it easy for us to statement since the election, projections for growth make judgments about the likely market for our seem to be reduced. We have had the OECD report exports. This is a time not to try to fine tune and alter today projecting a contraction in the next two quarters the growth rates over the next one or two quarters, but in the UK outlook. What is your view? rather to think about the next three, four or five years. Sir Mervyn King: The view we have is the one we set out in the November inflation report, where we Q34 Mr McFadden: On that note, I would like to said that in the fourth quarter of this year and the first turn to Martin Weale and ask about the trend rate of quarter of next, broadly speaking our central view is growth. You have given a statement saying that there one of roughly flat output with growth close to zero. is no reason to expect growth below the historical Thereafter, there will be some pick-up, but over the trend in the future. That is a big assumption, is it not? first year of the forecast, going through to autumn next It is a big assumption behind what the Bank does, and year, we do not see rapid growth at all. We made the it is hugely important to the economy. Do you believe downward revision that the Chairman asked me about that, given what we have been through in the last three at the beginning. Thereafter, we see some return to years or so, we can get back to historic trend rates of more normal growth rates. growth in the next couple of years? cobber Pack: U PL: COE1 [E] Processed: [03-01-2012 12:39] Job: 017636 Unit: PG01 Source: /MILES/PKU/INPUT/017636/017636_o001_th_TC 28 11 11 Corrected.xml

Ev 6 Treasury Committee: Evidence

28 November 2011 Sir Mervyn King, Paul Fisher, Dr Ben Broadbent and Dr Martin Weale CBE

Dr Weale: First of all, it is important to remember that first of all, in terms of the rise in energy and food even if we get back to historic trend rates of growth prices, which brought about a squeeze on real take- and we do not have any element of recovery, output home pay and dampened consumption more than we will be a very long way below where one would have had expected, and secondly now, in terms of the expected it to be in the absence of the crisis—possibly problems within the euro area, which of course some 10 percentage points below. That is a movement renewed concern about the health of not just the euro that really has no historical parallel for Britain, so area banking system, but banking systems right even if we get back to historic trend rates of growth, around the industrialised world. That is why this is an we will be quite a lot worse off than we would have issue that all my colleagues at central bank level take been. Essentially, however, the basis behind what I seriously and talk to each other about. It has raised said was, as the Governor said earlier, that we do not the cost to banks of obtaining funding and hence, in think the underlying factors that have supported trend turn, the cost of borrowing to companies and growth in productivity over quite a long time—things households. Those are enormous challenges and it will like improving education, the standard of the labour not be easy to get through this. There will need to be force, research and development and the stimulus of a significant amount of rationalisation of the debts and importing new ideas from abroad—have credits in the world before we finally emerge from the fundamentally changed. We certainly know, as end of this period. happened in Japan, that countries can have periods of rather poor productivity performance. I certainly Q37 Mr McFadden: How much do the Bank and the would not say that sort of thing could not happen here, MPC consider the human cost of all this when they but I have no reason to believe that it is likely to come to their decisions? We have unemployment at a happen. 17-year high. We have 1 million young unemployed people. In your former home town of Wolverhampton, Q35 Mr McFadden: So the message from the Bank which I represent, unemployment is more than 12% to the country is not that we have to get used to lower now; it is the 14th highest in the country. How much growth for a long time to come. does that basic human cost of coping with this crisis Dr Weale: I do not have any reason to think that come into the MPC’s decisions? underlying growth will be lower for a many years to Sir Mervyn King: We are all very concerned about it; come. Again, I stress that as we have said repeatedly, it is one reason why many of us have moved into this the future is uncertain, and estimates and underlying career and why we are interested in policy making. I trends are also uncertain, but there is no reason to think the best contribution that the Bank of England think that underlying trend growth rates have can make is by meeting our remit to bring inflation deteriorated markedly. back to the target over the medium term, but we have Sir Mervyn King: In the long run, I am sure we can been very careful over the past two to three years to get back to historical growth rates, but I have no idea say that our remit includes the requirement that we do over what horizon, because I think that ultimately this not cause undesirable volatility in output. That is why, is linked to the rebalancing of the world economy. for some considerable time now, we have had to put What is going on in the euro area is an example of up with the criticism that we permitted inflation rates that, but it is not the only aspect; the trade surpluses of around 5%. We deliberately did not take action to in China and the deficit in the United States are other bring the rate down quickly to 2%, because to do so examples. Until those problems have been resolved, would undoubtedly have meant falling money wages, all countries are likely to face a period when there rising unemployment and a deep recession. I do not will be unexpected credit losses, and adjusting to that think that that would have been desirable. I do not will be a rather painful and unpleasant episode. I do think that it would have been consistent with the remit not know how long it will take but once it is over, I see no reason why we cannot get back to the long-run that we were given and it is not the measure that we growth rates that we experienced in the past, which have actually taken. were stable for quite a long time. In the long run, the right thing to do—it is what we are looking at every month—is to ensure that when Q36 Mr McFadden: Looking at the basic policy looking two years or so ahead, we are on track to division between the Bank and the Government on bring inflation down to the target. The reason why we this in the last couple of years, the Bank has been have expanded our asset purchases is because, in our running a loose monetary policy and the Government, latest forecast, we felt that the balance of risk was since the election, have been running a tight fiscal that inflation might actually be below the target, thus policy. That is not producing economic growth. We justifying further monetary expansion, despite the have had a year of pretty flat growth. What other current high level of inflation at 5%. weapons are in the locker, if the current twin division of responsibilities is not producing growth? Q38 Chair: Just to be clear on those remarks about Sir Mervyn King: The idea of a combination of a tight the broader economic effects, you are not, are you, fiscal and easy monetary policy would actually be a making an implicit bid there for a change in your standard textbook response to the problems that we remit? faced—a situation with a large fiscal deficit, a current Sir Mervyn King: Certainly not. account deficit, and the need to rebalance the economy. What has happened is that we are facing Q39 Chair: You do not want it more towards, for extraordinary headwinds from the rest of the world: example, the remit under which the Fed operates. cobber Pack: U PL: COE1 [O] Processed: [03-01-2012 12:39] Job: 017636 Unit: PG01 Source: /MILES/PKU/INPUT/017636/017636_o001_th_TC 28 11 11 Corrected.xml

Treasury Committee: Evidence Ev 7

28 November 2011 Sir Mervyn King, Paul Fisher, Dr Ben Broadbent and Dr Martin Weale CBE

Sir Mervyn King: Absolutely not. We have a very and the changes and disturbance to the banking clear remit, which is to hit the inflation target, but the system, which are unprecedented in UK banking remit clearly says that from time to time there will be history—to have several of our major banks in deep shocks to inflation, like the shock from VAT or from trouble, pushing up on credit spreads in the way that energy prices last year, which mean that to meet the they have. That has made life extraordinarily difficult. inflation target immediately would cause undesirable There is no model that enables you to take that into volatility of output and employment. It is therefore account. These are judgments about how long the necessary to look further ahead, to when those crisis will persist. One of the things that we failed to temporary shocks drop out. If we had raised interest understand was how long it would take for conditions rates significantly, to ensure that inflation was 2% in banking markets to get back to anything remotely today, not only would that have caused far greater close to normal. In 2009, I think the central view was unemployment and loss of output, but we would now that by now funding conditions in banking markets be confronted with the prospect of inflation being well would be better than they were then. In fact, if below target and we would be in a position where we anything, they are worse. That is a surprise, and it is had rather little we could do about it. something that we have had to take into account, but it is one of the factors that has made life extremely Q40 Mr Ruffley: Governor, I want to ask about difficult in assessing where the economy is going. inflation forecasts. There is no need to repeat what you said to Andy Love about it being a distribution and so on. You were very good at the start of this Q44 Mr Ruffley: What contribution to the overshoot decade; the average forecast error for inflation one in inflation do you think the first round of QE made? year out between 2001 and 2004 was 0.1%. Between Sir Mervyn King: Inflation would have been certainly 2004 and 2007, it was 0.3%. From 2007 to 2010, it a bit lower, and we discussed that in our Quarterly was 1.3%. In the last 12 months, from November last Bulletin article. year compared with this month, it is 1.5% adrift. Excluding what you said before about the VAT Q45 Chair: I think you had the figure of 1% in there. increase, world commodity prices and the effect of Sir Mervyn King: In terms of the scale of the amount the depreciation in sterling—taking those out of the of QE we did, the asset purchases we did and the equation—what do you think in the model has £200 billion. But we did that because we thought that contributed to the worsening forecast performance? without that the risk to inflation was on the downside. Sir Mervyn King: Nothing, because if you take those When we made those decisions we did not know the factors out, there is nothing else to explain. I do not scale of the energy price increase, the scale of the VAT like the word “error” because no one can know what increase and so on. Those are factors that come along, the future might hold. It is a technical term. The and we have to accept them. We decided, as I magnitude of those is entirely driven by shocks to the explained earlier, not to offset those when we saw world and UK economy from outside. If you get very them coming in, because to do so would have been large and unexpected shocks, you will get very large very damaging to the real economy. They would also “forecast errors”. have made life more difficult for us in the medium term, because the balance of risks would have been Q41 Mr Ruffley: I just want to ask about the model. that inflation would fall below target at a time when In reply to Mr Love earlier, I think you, Dr Broadbent, we would have been hard pressed to find more used the words that you as a Bank were trying to instruments to ensure that inflation would pick up. understand what has gone on in relation to the output gap. How far is your reliance on the output gap Q46 Mr Ruffley: Could you list the factors that responsible for these overshoots in inflation? prompted the MPC to go for another round of QE? Sir Mervyn King: I do not think that it is. The Sir Mervyn King: I think it was the change in the overshoot in inflation is not because we have had an excessively buoyant economy growing rapidly and outlook between August and now, which I have putting pressure on capacity. explained. You have seen the very sharp downward revision in the growth outlook, and although the Q42 Mr Ruffley: I mean overshooting the forecast. growth rates in the second and third years have not Sir Mervyn King: Yes. If we had overestimated the changed very much, it means that the level of output amount of capacity in the economy, therefore the that we are projecting—the whole distribution of the economy had grown sufficiently rapidly to press on levels of output—is markedly below in our current capacity, pushing up domestically generated inflation, view what it was in August, for all the reasons I have you would not have seen subdued wage inflation and given connected with the euro area and the knock-on you would not have seen rising unemployment. So I effect on credit conditions. do not think it is domestically generated inflation; if anything, domestically generated inflation has Q47 Andrea Leadsom: Dr Broadbent, if I sell you probably been below where we thought it was going something for £1 and buy it back from you at £1.10, to be. It is the external factors that have pushed it up. what is your financial position? Dr Broadbent: It depends what has happened to the Q43 Mr Ruffley: So it is purely external. underlying value of the thing I have bought from you. Sir Mervyn King: There are other things that make I would not sell it to you at less than that. Can you be life very difficult at present: the nature of the crisis, a bit more concrete? cobber Pack: U PL: COE1 [E] Processed: [03-01-2012 12:39] Job: 017636 Unit: PG01 Source: /MILES/PKU/INPUT/017636/017636_o001_th_TC 28 11 11 Corrected.xml

Ev 8 Treasury Committee: Evidence

28 November 2011 Sir Mervyn King, Paul Fisher, Dr Ben Broadbent and Dr Martin Weale CBE

Q48 Andrea Leadsom: No, it is simple maths. If I profit or a loss, you cannot possibly not have made sell something to you at one price and buy it back the opposite side of the trade. from you at a higher price, have you made money? Dr Broadbent: But this goes on all the time. There Chair: In nominal terms, Dr Broadbent, just to define might be a private sector organisation—let us say a the question. pension fund or an insurance company—that buys a Dr Broadbent: Yes. gilt at a certain price, and then the value of that gilt may rise or fall subsequently. Q49 Andrea Leadsom: You have made money. So if I sell you £100-worth of gilts at £80, having bought Q55 Andrea Leadsom: Absolutely, and that is how them from you previously at £100, what is your profits and losses are made. position then? Dr Broadbent: So leaving aside the Bank of England Dr Broadbent: If you are asking about QE and the in this for the moment, who is on which side of the benefits to the Bank of England’s balance sheet— transaction in that case? Suppose a private sector investor buys a gilt and then interest rates fall, and Q50 Andrea Leadsom: Would you just answer? that private sector entity has therefore made money in Have you made twenty quid? some sense from that transaction, who in that case has Dr Broadbent: Yes, in a sense, but I am part of the lost money? There is no Bank of England Government as well, and if the Government is involvement. selling me—

Q51 Andrea Leadsom: This is my point: I am very Q56 Andrea Leadsom: The point is that on this keen to establish that if I buy something from you at occasion the Bank is that private investor. The Bank £1 and sell it back to you at 80p, you have made 20p has bought gilts and will be selling gilts. Therefore, on the transaction and, therefore, in theory I have lost by definition, if the two prices are different, the Bank 20p on the transaction, because I have sold it to you has either made a profit or a loss. I just simply cannot for less than I bought it from you. Why, therefore, is understand the Governor’s response to the question. the Governor right to say that in terms of unwinding Sir Mervyn King: Shall I try to help you out, briefly, the asset purchases there is no loss when it is being Mrs Leadsom? bought from the market originally and sold back to Andrea Leadsom: Please do. Thank you, Governor. the market subsequently? The Governor says in his Sir Mervyn King: There is a narrow point, which is letter to the Chairman, “Any profit or loss arising from accounting. My point was simply that if the central movements in the market price of the gilts held by the Government had the same accounting conventions as asset purchase facility would be offset by a loss or the asset purchase fund, mark to market, you would profit for the Government as issuer of the gilts.” Why find, as I said in the letter, that the gain on one would is that right? be offset by the loss to another, because what is the Dr Broadbent: Because that is the party on the other asset to one party is a liability to another. side of the transaction, ultimately. I do not think that is a terribly interesting question to ask. The really interesting question to ask about the Q52 Andrea Leadsom: But it is not, is it? You have asset purchases is what is the counterfactual if we had bought the gilts from the market; you have not bought not made the asset purchases? I suspect your question them from the Treasury. Now you have sold them is trying to tease that out. That is a very different back to the market, potentially at a lower price— question. granted, potentially at a higher price. My point is—I will come back to this—that the Dr Broadbent: But then the value of the obligation, measure of profit and loss on our asset purchase fund which is the Government’s obligation, has also fallen. should be of no interest to anyone. At present, we happen to have a very large profit—a staggeringly Q53 Andrea Leadsom: No, it hasn’t. The large profit—in our fund. We do not regard that as a Government issued them at par— sign of great triumph or success. Ultimately, I hope Dr Broadbent: The price of the gilt is what you are we will get to the point when interest rates are back suggesting has fallen, and that is the value of public to more normal levels; that will be a sign of success sector debt. Let me make another point first of all: these transactions are not on the central bank’s for everybody, because it would be a symptom of a balance sheet; they are off the balance sheet and healthy economy. But if that were the case, the same indemnified by the Government. In that sense— mark to market accounting would show that the beyond going into any deeper questions—the Government had a profit, because the value of its transactions have no impact on our balance sheet. liabilities would have gone down, and we would have a loss, because the value of our assets would have Q54 Andrea Leadsom: No, that is simply not true. gone down, so I do not think these mark to market If you bought the gilts off the Government, then I accounting valuations tell you anything. agree that it is a Government liability and it is a Bank If you look at the public sector as a consolidated asset, and if you subsequently sold them back to the group, which you should, the mark to market profit to Government, it is now flat; I completely agree. But if one is a loss to the other. The interesting question is you buy them from the market at one price and then what is the counterfactual? If we had not made these you sell them back to the market at another price, so asset purchases, all the interest rates would be that the person the other side of the trade makes a different. cobber Pack: U PL: COE1 [O] Processed: [03-01-2012 12:39] Job: 017636 Unit: PG01 Source: /MILES/PKU/INPUT/017636/017636_o001_th_TC 28 11 11 Corrected.xml

Treasury Committee: Evidence Ev 9

28 November 2011 Sir Mervyn King, Paul Fisher, Dr Ben Broadbent and Dr Martin Weale CBE

Q57 Andrea Leadsom: Can I just make one point Q61 Chair: Come back once more on it, Governor, please, Governor? I have to disagree with you, and then I’ll move on to Michael Fallon. because the market is standing in-between. I just Sir Mervyn King: This is a positive lunch. Everybody plainly think you are wrong. I have talked to a number is better off because of the actions that we have taken. of people in the markets who also think that you are If we ever get back to the point where the value in wrong. our portfolio of the gilts has gone down, I will regard Sir Mervyn King: Let me just refer you to the this as a triumph because it means we will be back to standard accounting practices of all banks and all a world with more normal levels of interest rates and financial institutions. hence more normal levels of growth, output and employment. Anything the Monetary Policy Q58 Andrea Leadsom: It is not about accounting; it Committee can do to get us back to a world where the is about the fact that if I sell you something more economy is sufficiently strong that market interest cheaply than I bought it from you, you have made a rates have risen so that they have confidence that profit and therefore I have to have made a loss. It is people can earn real rates of interest—if we can raise not about the accounting; it is about the simple fact bank rate; if we can get back to that more normal that unless you sell those gilts at the same price you world—that is the moment when I will say that paid for them, you have made a loss. monetary policy has been successful. You may think, You can say to me now you are making a staggering “Gosh, there is a terrible accounting loss.” I will come profit. You said yourself to us, the last time you gave back and say, “Mark to market for the public sector evidence, that your intention when you came to as a whole, it’s a wash”. Neither of those things will tighten the money supply was to raise interest rates to matter a bit to people out there in the real world and set the direction and then to unwind the asset your voters. All they will care about is the health of purchases to push the yield curve up. Well the yield the British economy. curve is going to go like that. Sir Mervyn King: Yes, absolutely. Q62 Chair: Still you’ve got an indemnity. Sir Mervyn King: Well, that makes the point, Q59 Andrea Leadsom: You have referred to a doesn’t it? counterfactual. What I am trying to establish is that there is the potential for a whacking great loss to the Q63 Chair: That depends. I think it makes a number taxpayer. There is that potential. I still believe that of points. there is and I believe that your analysis of it is just Sir Mervyn King: Whatever the Government can wrong. Secondly, I then think— make or lose on mark to market with the indemnity Sir Mervyn King: Let’s just beg to differ on that. Let’s needs to be matched up with the mark to market go back to the counterfactual, which is what would assessment of its other liabilities. have happened to the British economy if we had not Chair: Andrea is particularly keen to come back with carried out these asset purchases. That ought to be the one more quick rejoinder. test. Of course, that is exactly the same test that you would apply to a monetary policy move that involved Q64 Andrea Leadsom: So are you saying then, interest rates. No member of this Committee has ever Governor, that there is absolutely no cost to said to us, “Gosh, you’ve raised or lowered bank rate. quantitative easing? It is absolutely a free, good thing That has changed the interest rate on Government and there is absolutely no downside and no risk from securities, so of the people buying or selling them, it whatever? some would have made losses and others would have Sir Mervyn King: There are risks associated with any made profits.” You ask us the question: does this monetary policy move and those risks are associated monetary policy move make sense from the point of with the fact that if we make misjudgments, inflation view of the UK economy? That is the judgment that will either be too low or too high relative to the target. you should use when judging asset purchases, not But that is the ultimate cost of this. whether the fund happens to make some accounting profit or loss. Q65 Michael Fallon: Shall we bring Paul Fisher off the bench and give him a chance? The Bank has done Q60 Andrea Leadsom: What concerns me is that an assessment of the first round of quantitative easing there is no forward assessment being done by the and reports that there is “little evidence that effective Bank on the unwinding of the quantitative easing. We new bank lending rates for households or firms fell are now in a position where the European Central significantly following QE purchases”. Shouldn’t Bank could be doing what you have been doing, and they? they are not doing that for various reasons, including Paul Fisher: Yes, well at the same time as we were the fact that they are concerned about the impact on doing QE, the financial sector tensions were emerging domestic inflation in the eurozone. Yet we are taking and credit spreads were widening. If we had not the view in this country that QE is a free lunch and undertaken QE and pushed down risk-free rates, you the Bank’s own assessment suggests that QE accounts would have seen even higher rates for businesses and for 1.5% on gross domestic product, which is individual borrowing. One of the focuses of a lot of basically all the growth in the economy since the studies on the impact of asset purchases is on the financial crisis. There has been no assessment of the effect on interest rates. It is not the only channel. It is cost of unwinding it. not the channel that I, myself, tend to focus on when Sir Mervyn King: That is not true at all. explaining it to people. It is much more about getting cobber Pack: U PL: COE1 [E] Processed: [03-01-2012 12:39] Job: 017636 Unit: PG01 Source: /MILES/PKU/INPUT/017636/017636_o001_th_TC 28 11 11 Corrected.xml

Ev 10 Treasury Committee: Evidence

28 November 2011 Sir Mervyn King, Paul Fisher, Dr Ben Broadbent and Dr Martin Weale CBE a quantity of money into the economy in order to Q71 Michael Fallon: Is there concern that the increase nominal demand directly. transmission mechanism of QE may not work this time in the same way it did last time? Q66 Michael Fallon: Yes, but when you came to Paul Fisher: The broad picture would have to be the take your decision to authorise the second round of same; the broad mechanisms would be the same. Of QE did you not weigh at all the impact it was likely course, again when you change interest rates, it never to have on new bank lending rates? has identical effects on the economy. It always Paul Fisher: Bank lending is not one of the main depends on the circumstances in which you are doing channels I would use to describe the impact of asset it. The differences will be there. The same will be true purchases. The effect could actually be to push bank here. We start from a much lower level of interest lending down. Let me give an example. If we put rates, for example. We start in relatively different enough money out there on to investors’ balance financial conditions, and different financial markets. sheets, they go off and buy corporate bonds; the So, the effects will be slightly different, but in the corporates end up with more cash and they may broad picture I would expect the overall scale of it to choose to repay their bank lending as a result of that. be the same. So the effect on bank lending could go either way but you have already had a beneficial impact on the Q72 Michael Fallon: Were you surprised that the economy because the corporate is in a better place OECD this morning forecast that you might increase than it was before. So the effect on bank lending is to £400 billion in the early part of 2012? not for me one of the main channels through which Paul Fisher: People who believe in crystal balls and QE works. In fact, the whole point of asset purchases point estimates are best avoided. I don’t know yet is to bypass the banking system and get money out what the amount of QE we will end up doing will be. into the economy proper, not just give it to banks. I didn’t know in the first round until we came to a stop, and we decided that 200 was the right number Q67 Michael Fallon: The minutes of your meeting at which to stop. I feel much the same about this on 9–10 November say that there was a range of views round. We have announced 75; we will do 75. If we among Committee members about the likely strength think we need to do more, we can do more. of the factors involved in assessing QE. What is that range of views? Q73 Michael Fallon: When will you assess the Paul Fisher: The difference is of emphasis and second round? nuance really, rather than wholesale difference of Paul Fisher: We are assessing the economic view. We all sign up to the broad picture of the way conditions as we go. We will not learn that much more the economy works and the different channels. Some about the impact of asset purchases over the three and people place slightly more emphasis on some of those a half to four months we are doing it, but we will channels than others. The striking thing is the extent learn about the economy, and about the development to which we agree, rather than the extent to which we of the situation in the eurozone. We will be able to disagree. I wouldn’t want to over-emphasise those take a fresh look at the medium-term position, and disagreements. then decide whether we need to do more. I said in an interview over the weekend that £75 billion for me Q68 Michael Fallon: But the minutes do. As I said, was the smallest amount I was sure we would need to they say, “There remained a range of views about the do, and then we could come back to it and see whether likely strength of the different factors.” we wanted to do another round. Paul Fisher: Yes, so some people think that they will have a slightly stronger effect than others. Q74 Michael Fallon: Would you come back to it before you had done the kind of assessment of the Q69 Chair: It is a bit more than a range of nuances, second round that you did of the first? isn’t it? Paul Fisher: We will not learn that much about the Paul Fisher: “Nuances” was a description of the impact of asset purchases over a short period of three various channels through which QE works. There is a or four months. It takes a year to 18 months to come range of views, but most people think QE will have through fully, but we will learn more about the some impact, and that that impact will be positive. We economy, and we will have a new assessment of the are arguing about relatively small differences about medium-term outlook. exactly what the strength is. That will be exactly the same for a change in interest rates. There will be a Q75 Michael Fallon: What do you say to the variety of views about the impact of interest rates on suggestion that essentially, because this is all so new, the economy at one moment in time. Some people you are all flying slightly blind on this? think it would have a stronger effect than others. It is Paul Fisher: We are all making decisions under not really any different for asset purchases. uncertainty. That is always true of monetary policy. It is particularly true now, because we are recovering Q70 Michael Fallon: When you say “most people”, from a recession the like of which we have not seen are there members of the Committee who doubt the since the great depression; we have got a global effectiveness of QE in boosting demand? financial crisis that we have never seen before; we Paul Fisher: Other people would have to speak for have had this very unusual shift in productivity themselves. I am not aware that anybody says it would apparently, which we cannot explain from experience. have no impact. We are in a situation we have not seen before in UK cobber Pack: U PL: COE1 [O] Processed: [03-01-2012 12:40] Job: 017636 Unit: PG01 Source: /MILES/PKU/INPUT/017636/017636_o001_th_TC 28 11 11 Corrected.xml

Treasury Committee: Evidence Ev 11

28 November 2011 Sir Mervyn King, Paul Fisher, Dr Ben Broadbent and Dr Martin Weale CBE economic history, so of course there is huge money into the system to increase liquidity, or are you uncertainty out there. Add on to that the sovereign trying to control bond yields? debt crisis in Europe, and of course the uncertainty Paul Fisher: We are not trying to control liquidity as just becomes enormous. But we have to make such; we are trying to increase the amount of money decisions and we have to try to make the best in the economy. That, for me, is the first purpose. One decisions we can, given the balance of risks as we of the consequences of that is that it will push down currently assess them, and get on and do that. bond yields, which is just one of the channels through which QE works. QE forces people who get that Q76 Michael Fallon: What makes you money to go off and buy some other asset. Since QE2 uncomfortable at the moment about going beyond started, if you like, we have bought about £35 billion £75 billion? of bonds. That is £35 billion in gilts that somebody is Paul Fisher: First, we have a certain period in which not holding but would have held, so they must be to buy those assets. The markets at the moment are holding something else, which is the main way that not functioning fully, generally across a whole range asset purchases work. They then have to go and buy of financial markets. I feel that we are going at about some other instrument that they would not have the right rate at which we can acquire assets. It is a purchased, which will include things such as corporate question of just how far ahead you can see into the bonds, equities and the sort of things that help to boost future. Nobody actually likes the asset purchases; it is the economy. not a normal policy instrument. If I thought we could get away with doing less, I would prefer that, but, Q82 Mark Garnier: They could hold on to their gilts nevertheless, I am quite prepared to do it if that is the until such time as your demand for them has pushed option we have on the table. We will do whatever we the yield even lower. think is necessary to meet our remit. Paul Fisher: They could, and doubtless some people will choose the right time for them to sell the gilts, but Q77 Chair: You said a moment ago, Mr Fisher, that we have actually successfully bought that many gilts. we are going at about the right rate of purchasing these assets, but your minutes state: “The Committee Q83 Mark Garnier: Here is an important question: noted that…market capacity made it difficult to would you say that the current gilt yield is a reflection increase the monthly rate of purchases substantially of the Government’s policy or of the activities of you above what was already under way.” So you cannot guys in the bond market? go any faster? Paul Fisher: It is both. Paul Fisher: We could go faster. I think what we are doing now is about the right rate. The faster we go, Q84 Mark Garnier: Which is having more of an the more risk there is that some of our operations do effect? not quite deliver the amount of gilts we want to Paul Fisher: It is a bit early give an estimate of how purchase. There is a certain capacity in the market to much gilt yields are being depressed as a result of the supply gilts, depending on how much risk the market asset purchase programme. makers are allowed to take, and we have to reflect that in the scale of our operations. Can we always go a bit Q85 Mark Garnier: So it is more likely to be faster? Yes, but the risk builds up of you having some general confidence? disorderly operations, which I do not think we would Paul Fisher: It is a mix. particularly like to see. Q86 Mark Garnier: Okay. You will be pleased to Q78 Chair: It is not going to be easy to ramp this hear that I am going to change the subject to up, is it? You are saying so yourself that it is difficult consumer demand. to get these purchases away any faster than you are I would like to canvass opinions from each of you. In doing now. your report you talk quite a lot about recoveries after banking crises tending to be a lot slower than average. Paul Fisher: We can then do some more. Given continuing weak growth in domestic consumption, how quickly do you think the recovery Q79 Chair: Afterwards. Later. can occur? Paul Fisher: Yes. Dr Broadbent: Over longer periods of time, I am not sure whether consumer confidence determines growth. Q80 Chair: So it is the maximum current rate, and The more important consideration if you are thinking then you just carry on indefinitely? about growth over two, three or four years is Paul Fisher: I would not say that it is the maximum. underlying productivity growth, which we discussed I have always said to the Committee that, if they want earlier. Having said that, as the Governor said, we to go faster, we can go faster, but it is more risky the have seen steep falls in consumption. Recently I faster you go. would attribute a lot of that, certainly over the past year or two, to very weak real income growth, itself Q81 Mark Garnier: May I carry on with this the result of hits to VAT and, more importantly, to quantitative easing question? Clearly the MPC’s job energy prices and weak productivity. Looking ahead, is to keep inflation at a pre-defined rate. When you that is one relatively bright aspect of the projections. are in the markets making an asset purchase, what is As long as we do not get increases in those costs on your primary objective? Are you trying to pump the scale that we have seen over the last year or two cobber Pack: U PL: COE1 [E] Processed: [03-01-2012 12:40] Job: 017636 Unit: PG01 Source: /MILES/PKU/INPUT/017636/017636_o001_th_TC 28 11 11 Corrected.xml

Ev 12 Treasury Committee: Evidence

28 November 2011 Sir Mervyn King, Paul Fisher, Dr Ben Broadbent and Dr Martin Weale CBE and it is hard to see them on that scale—then real Q87 Mark Garnier: We are in quite a difficult place, income growth, and consumption growth, too, will because you note that Government consumption has improve. Whether that means that growth in the accounted for almost half of growth, but that is economy overall improves to the same extent is much unlikely to continue with the fiscal consolidation, and harder to say in the face of these other head winds. It then we look at household consumption. I was just is more likely that the troubles in the eurozone will making a quick note earlier about the problems that show up in other areas of demand—exports, the household consumer has. They have very limited investment and so on—rather than in consumption. So access to credit. They have too much debt, so to a I would not want to hang the fortunes of the economy certain extent we are asking them to deleverage. The entirely on household spending growth. savings ratios are still relatively low—they have gone Paul Fisher: Household spending growth has been up and they have come down a little bit, but remarkably flat for a long time, and consumer nevertheless they are still relatively low—so people confidence has been falling quite sharply. Consumer do not have a huge amount of savings. People have confidence, as best as we can see, does not contain very poor pension provisions, and they are living very much extra information in itself. It embodies all longer, so their reliance on pensions is going to be of the other factors that are going on in the economy greater. There is very limited confidence, as you said. like unemployment, inflation and so on. So it is a good You have falling real incomes. To a certain extent, summary statistic sometimes, but it does not give us people are still working part-time jobs, rather than new information. We can all see various reasons why full-time jobs. Then, to a certain extent, we are trying consumer confidence would have been weak, to encourage people to spend more money in the high including the international financial crisis and the fact street in order to promote growth. that we have fiscal consolidation going on. There really are some extraordinarily confusing Now, I think the most likely impact over the short run messages going out to the consumer. What should we that will lead to recovery in consumption will be when be saying to the consumer to try to encourage them to inflation drops off next year. That should restore some help participate in the economic recovery? Or is that notion of real income growth and make people start just something that is too difficult? to feel a bit better off again. I am envisaging that Sir Mervyn King: To pretend that we should be giving consumption will stay flat for a while and will then messages to consumers is too much, and they can come back, but, as Ben says, it is probably not the work it out for themselves. They can see in their daily major medium-term driver of the economy. It is lives all the factors that you have just mentioned. It is something that affects short-run dynamics. important to recognise that the position of different Dr Weale: I would like to say that what has happened consumers varies a lot. As you said, the household to consumption since the start of the crisis is sector is highly indebted and in aggregate I am sure essentially without precedent in the United Kingdom’s that the total burden of debt will be run down, but of history. If you look at income not relative to where it course within that, some households need to be able was last year, but relative to where it was at the start to borrow. Some householders would like to be able of the crisis, it is at broadly the same level, but, as the to enter home ownership, others who are at the other Governor said earlier, consumption is something like end of their lifetime would like to sell houses. It is five to six percentage points lower than it was at the hard to sell houses to people who cannot borrow in start of the crisis. Obviously, things like investment order to be on the other side of the market. have fallen a lot as well. They have fallen more in The general comment I would make is that before the percentage terms, but it is the movement in crisis hit, it was very clear—this had been said in consumption that is more unusual. speeches for 10 years or more—that we had pushed Now, there are a number of reasons why that might up total UK consumption, both private and public have happened. One might simply be that people together, to an unsustainable level. That was done for concluded that they were living beyond their means good reason—to ensure that full employment could before the crisis, and they found themselves hanged persist when we had a trade deficit resulting from a on an expectation of plenty. So that is one possibility. high exchange rate and a strategy of trade surpluses Another possibility is that they simply concluded—it on the part of many countries in Asia—but there we is in some ways related—that future incomes are not were with an unsustainable level of domestic demand. going to grow in the way that they had hoped and At some point, that had to adjust. therefore they need to be saving more. They may be Many years earlier, the point had been made that the more worried about unemployment than they were. longer we left it to make that adjustment, the bigger They may finally have realised that old age is coming the adjustment would turn out to be, but there was no to more people and for longer than it used to and that easy way through this. Now, events have conspired to some higher level of saving is needed. start to bring about that adjustment. It will not be easy I share the view that, as the pressure on prices fades or painless, but it is clearly under way in this country away and real income starts to recover, it is likely that and there is a strategy for dealing with it. There is a we will see some upward movement in consumption, strategy for ensuring that the alternative sources of but I would also like to make the point that if the demand that Martin mentioned, in being particular economy is to follow a well balanced recovery, what exports, can work, because the exchange rate is 25% that essentially means is that the extra missing lower than it was. This is all part of the strategy to demand has to be largely filled by components of rebalance the economy. demand other than consumption—essentially It will be difficult, and it is not easy for us to give investment and net exports. simple messages. As I have explained in speeches cobber Pack: U PL: COE1 [O] Processed: [03-01-2012 12:40] Job: 017636 Unit: PG01 Source: /MILES/PKU/INPUT/017636/017636_o001_th_TC 28 11 11 Corrected.xml

Treasury Committee: Evidence Ev 13

28 November 2011 Sir Mervyn King, Paul Fisher, Dr Ben Broadbent and Dr Martin Weale CBE before, at present, the MPC faces an extraordinarily Q91 Mr Mudie: For the ordinary lad on the street difficult balancing act—a paradox of policy. In the who is looking in on this, does that mean that small short run you may want to expand those bits of businesses are getting more money or less? demand that you can influence, which is largely Sir Mervyn King: Less. domestic demand, knowing that in the long run you need a higher savings ratio in the economy and Q92 Mr Mudie: Does that worry you? demand will have to come from elsewhere. Hence, in Sir Mervyn King: Yes. the short run, we are tempted to do things that we know are the opposite of what we need to do in the Q93 Mr Mudie: Under the terms of the agreement, long run. Therein lies the tension between how far we are they breaking it? go in the short run—how many asset purchases we Sir Mervyn King: No, I do not think they are. As I engage in—and how far we accept that this said, the agreement was not defined in terms of net adjustment must be made and that it will be painful. lending, which is the economically relevant definition.

Q88 Mr Mudie: With the wholesale funding Q94 Mr Mudie: So this Project Merlin is not as good problems and European problems, is significant as it sounds for the lads out on the field. Could you deleveraging taking place in the banks? If so, how is supply us with figures? We are trying to put down that affecting lending? some markers. Since the business started with banks, Sir Mervyn King: I think it is still going on, but it is we have never ever been able to pin them down and not as bad here as it is now in the euro-area economy, get them to agree certain lending targets. Even last where the view among my peers is that already the week, they refused to—not refused to, some of them deleveraging of euro-area banks is leading to early did not know, incredibly. They were short on figures. signs of a credit crunch, with concerns that it will get Could you supply the Committee with some figures worse. You can see that even for banks in this country, that will let us continue to monitor, with yourself, and indeed US banks, funding problems have what is happening? worsened since August. I think someone mentioned Sir Mervyn King: We already published those that the funding market in medium-term funding has numbers. The banks seem to pre-publish their own been closed. It is difficult for banks to get funding. gross lending facility numbers and we publish, on an The Financial Policy Committee will have more to agreed timetable, the numbers that correspond to the Merlin definitions—the gross lending numbers and the say about that later this week. Undoubtedly, they are net lending numbers of banks. real problems that will begin to affect the cost of credit down the road. Q95 Mr Mudie: We couldn’t get from them, Governor, whether they had sat down after the Q89 Mr Mudie: Your October report on trends in agreement was settled and divided the targets between lending showed that lending to businesses and small them. To your knowledge, can you tell the Committee and medium-sized enterprises was slowing—going whether there is an agreement between the banks for down. That was in the three months to August. Is it their individual targets? continuing as much as the banks, regional people— Sir Mervyn King: I have no idea and, as I have said, Sir Mervyn King: A consistent picture has been that we are not party to the agreement. That is a matter for net lending to businesses has been falling. It is closer Government and the banks. We are not involved in it. to being flat now, but it has still been falling; it is certainly not rising. Q96 Mr Mudie: But you are monitoring them. Sir Mervyn King: No, we are publishing the numbers Q90 Mr Mudie: How does it affect Project Merlin if which are submitted to us. the banks for small businesses have reached agreement with the Government and you are Q97 Mr Mudie: So you do not know whether they monitoring lending and it is going down? They were are above or below. here last week and they said how wonderfully well Sir Mervyn King: All we can publish are the numbers they were doing, although they would not give us that are submitted to us. any figures. Sir Mervyn King: The targets that are used in the Q98 Mr Mudie: The bigger question that I asked Merlin agreement—that is an agreement between the them was about your financial stability report, where Government and the banks; it does not involve the you publish a chart with the stock of UK banks’ Bank of England—are defined in terms of gross lending. When I asked them how satisfied they were, lending and facilities. In our report, we publish three I pointed out that half the lending went abroad and numbers: the facilities number, which is the number that by far the biggest part of their domestic lending on which Merlin is based, the gross lending number, went to other banks or financial corporations. The next which comes in through reports by banks to the Bank part went to households and the smallest part—the of England, and the net lending number, which also smallest sector in the whole description—went to comes in. The net lending number is the number that small businesses and medium enterprises. Now, if we is relevant to the availability of business finance and are talking about rebalancing the economy, surely, the finance that is available to support investment Governor, that has got to change. You cannot and growth. rebalance the make-up of the economy without the cobber Pack: U PL: COE1 [E] Processed: [03-01-2012 12:40] Job: 017636 Unit: PG01 Source: /MILES/PKU/INPUT/017636/017636_o001_th_TC 28 11 11 Corrected.xml

Ev 14 Treasury Committee: Evidence

28 November 2011 Sir Mervyn King, Paul Fisher, Dr Ben Broadbent and Dr Martin Weale CBE investment being much different from what has gone are going to rebalance the economy seriously, the in the past few years. banks with the money have got to start thinking of Sir Mervyn King: This is a point that has concerned readjusting their lending patterns to be more domestic us about the lending figures. It is why we have been and more targeted on that part of the economy that we worried about the position of the banks. The leverage all want to see grow? of the banking system increased dramatically before Sir Mervyn King: We certainly need to see the the crisis. It has come down significantly since then. banking system lending more to British non-financial Much of that deleveraging has indeed been to reduce companies, and within that, we need to see lending to the lending to other parts of the financial sector. In the SMEs. I do not think that the difficulty is that the five years running up to the crisis, two thirds of the banks are sitting down and being deliberately lending by banks was to other parts of the financial obstructive in not lending to SMEs. They are in the sector. A lot of that has been unwound. That is good, position where their own balance sheets are because it has not, in and of itself, led to a contraction sufficiently weak that people are not willing to lend of lending to the real economy. money to them at rates that make it easy to lend on. With banks under such pressure to deleverage, however, it is not surprising that they have reduced all Q102 Chair: I would like to ask a further question forms of lending. The reason why that is serious for related to that: the banks complain—privately a great the small and medium-sized enterprises is because deal and publicly somewhat—that this pressure on they do not have many alternatives to the banking their balance sheets is exacerbated by the liquidity and system. Bigger companies have gone round the banks. capital requirements now being imposed on them by It is true that the average of the biggest industrial regulators, even though those are not due to be companies in Britain can now borrow more cheaply implemented for some years. Markets are imposing than the average of our six biggest banks. That is a a discipline as a result of the increased transparency striking fact. They are disintermediating the banking requirements that have come with those capital and system by issuing corporate bonds and equity. liquidity requirements. Do you think that the banks Fortunately, those financial markets are working very are justified in their concern about this? efficiently, but SMEs are not in that position, and I Sir Mervyn King: No. I totally accept that this is think, as you point out, the rebalancing is very much clearly not the time to raise capital requirements, and focused on the “M” part of that—medium-sized they are not being raised. It has been announced that enterprises—and future innovation and ideas are very they will go up in years to come. The pressure on much linked to the “S” part of it. The SME sector is bank balance sheets now is coming, not from what the very important. regulators are doing, but from the realisation in the The sums involved are not enormous here; we market as to how risky the balance sheets of banks estimate the total stock of lending to SMEs to be actually are. Before 2007, people who lent money to somewhere between £100 billion and £150 billion, banks did so in a world of innocence where they and the amount of net lending to the SME sector, thought it completely safe to lend, particularly to big which occurred at the peak of say 2006–07, was about banks, because they would always been repaid or £10 billion a year. Last year, it shrank by £5 billion. bailed out, so they were willing to lend to banks at Clearly, the economy is not growing rapidly, so that interest rates only a few base points above bank rate. £10 billion looks to be more than SMEs would want Now, people realise how exposed the balance sheets to be able to borrow, but to turn the thing round, it is of all banks around the world are to what is going on going from minus 5 to plus 5—that is the rough order in the euro area. of magnitude. I am not trying to be precise in any sense. These sums are very small in comparison with Q103 Chair: Just to be clear, your view is that we the total balance sheets of banks. should be pretty dismissive of these moans that we are getting from the banks— Q99 Mr Mudie: That is right. I tried to get from Sir Mervyn King: I do not think that you should be— them their total lending—individually—and their Chair: On the specific issue that the regulators are lending to small and medium enterprises, and I failed. generating problems for them. Do you have a figure off the top of your head for their Sir Mervyn King: Yes, I think that there is an issue total lending? We could then see as a Committee how about liquidity requirements and whether at present small a part of that lending is actually going to the liquidity regulation is coming in too quickly. That British industry. is something that we are discussing on the Financial Sir Mervyn King: As I said, through work done by the Policy Committee and that I— Department of Business, we estimate the total stock of lending to SMEs to be somewhere between £100 Q104 Chair: It is something that I have raised billion and £150 billion. publicly. You are concerned about the liquidity side. Sir Mervyn King: Well, there is an issue to be Q100 Mr Mudie: But that is £150 billion out of discussed. what? What percentage of their total lending is that? Sir Mervyn King: Well, it is hundreds of billions as a Q105 Chair: But not on the capital side? total balance sheet. Sir Mervyn King: Not on the capital side, where I think market pressure means that the banks that can Q101 Mr Mudie: I am just getting an order to shut reveal that they have strong balance sheets and a lot up. I have one last question: do you agree that if we of capital will be able to obtain funding. I think that cobber Pack: U PL: COE1 [O] Processed: [03-01-2012 12:40] Job: 017636 Unit: PG01 Source: /MILES/PKU/INPUT/017636/017636_o001_th_TC 28 11 11 Corrected.xml

Treasury Committee: Evidence Ev 15

28 November 2011 Sir Mervyn King, Paul Fisher, Dr Ben Broadbent and Dr Martin Weale CBE this is a world in which transparency about banks’ appropriate measures to ensure that our policy was balance sheets will serve them very well. We have consistent with the fall in the exchange rate and that seen that in the euro area. If a bank can reveal that its we did not allow that fall in the exchange rate to carry exposures to self-evidently risky assets are lower than on. We have not seen increases in domestic cost the market expected, then they will benefit from that. inflation, which would erode the value of the depreciation in the exchange rate, so we have Q106 Stewart Hosie: Governor, you said in the maintained low rates of increase of domestic cost, report that the high level of uncertainty about inflation which will sharpen prices in the future. So we have and growth, and concern about tighter credit taken actions to ensure that that rebalancing can occur, conditions, had had only a modest effect on and we have been affected badly by an adverse investment so far. Why do you think that was? development in the rest of the world, primarily the Sir Mervyn King: Sorry, I missed the first part of the euro area but not exclusively—we are now seeing question. signs of slowing in Asia and the United States. The world has taken a turn for the worse in the past few Q107 Stewart Hosie: You said that the high level of months, and that is bound to affect what we can do. uncertainty about inflation and growth, and concern We cannot easily offset that. about tighter credit conditions, had had only a modest effect on investment. Why do you think that the effect Q111 Stewart Hosie: I appreciate that. Certainly was only modest? there were huge shocks to the demand side, not least Sir Mervyn King: Actually, I am not sure that I do what we have seen in the eurozone. But the OECD think it is only modest. Can we have the full quote, to forecasts for growth next year are still higher in the get the context? eurozone and the US than they are in the UK. On the supply side, if we have seen this huge peak-to-trough Q108 Stewart Hosie: It is in reference to chart 2.12; fall in business investment, is there anything that on page 26, the second paragraph: “reports from the monetary policy can do—you cannot comment on Bank’s Agents suggest that investment intentions, fiscal policy—to encourage business investment, although softening since the summer, still point to particularly in gross fixed capital formation, signalling modest increases in capital spending over the coming that they are ready for when the external market year. The prospects for investment in the medium term picks up? are discussed”, etc. Sir Mervyn King: The contribution of monetary Sir Mervyn King: That is a statement about the policy is to provide an environment in which interest absolute level of investment intentions, not the impact rates will remain low. One way or another, we have of uncertainty on it. That is true so far. Whether that done that. We are facing very low long-term interest persists, remains to be seen. But we are reporting there rates. That is the one factor that will be supportive to simply the views that the agents have come up with; investments. Having low long-term interest rates is a in part I think this is because investment plans are positive factor. But, in the end, what will matter is revised at infrequent intervals, and the concern that whether we can get to a point where people can see came up in our discussion in the Committee was that that the rest of world is returning to more stable around the year-end and the beginning of the year, conditions and our external picture is one where we many companies would review their investment would expect to pick up in net external demand to intentions for next year, and then we would see the offset the inevitable slowing of domestic demand. impact of recent uncertainty come through. That rebalancing will then take place, we will come through it and we will get back to more normal Q109 Stewart Hosie: I am glad you clarified that. I conditions. We are facing extraordinarily difficult was quite surprised when I saw that, because from conditions from overseas at precisely the point in our peak to trough on your chart 2.12, we are looking at rebalancing where we need growth from overseas to something like a 20% fall, from around £36 billion to make that rebalancing feasible. below £30 billion, then up a little recently. A 20% fall is a huge fall. Q112 Stewart Hosie: On that basis, given we are Sir Mervyn King: It is, although investment is very close to the zero band—we have been for some time volatile. I don’t want to dismiss it—it is a large fall, and may well be for some time in the future—it seems no question about it. inconceivable that the 8 to 11% business investment growth target laid out in the 2010 Budget for the Q110 Stewart Hosie: The question I have then is, whole of this Parliament can be met. can monetary policy on its own, assuming confidence Sir Mervyn King: Well, there were forecasts. We will returned, do enough to encourage growth in business have to wait and see what happens. Clearly if investment, or is there a requirement for a change in investment falls very sharply, it can appear to grow fiscal policy as well? quite rapidly in succeeding periods without ever Sir Mervyn King: Well, I am not going to comment getting back to the level that it was, so growth rates on fiscal policy, because that is elsewhere. What I can rebound. But, as I say, we do not pin much weight would say is this, that in a rebalancing position, there on precise forecasts at all. All I would say is that there is a serious limit to how far domestic economic policy are two sets of conditions that are important. One is can proceed by trying to stimulate further domestic that, in terms of domestic policy, we have very low demand when the need is to shift from domestic long-term interest rates which, all things being equal, demand to external demand. We had taken the are supportive to investment. We have got the basic cobber Pack: U PL: COE1 [E] Processed: [03-01-2012 12:40] Job: 017636 Unit: PG01 Source: /MILES/PKU/INPUT/017636/017636_o001_th_TC 28 11 11 Corrected.xml

Ev 16 Treasury Committee: Evidence

28 November 2011 Sir Mervyn King, Paul Fisher, Dr Ben Broadbent and Dr Martin Weale CBE conditions for a rebalancing in the UK economy, but future. The right thing to do with policy is to work we cannot pretend that we are immune to adverse out how you can think of a robust policy response movements in the rest of the world, particularly in that, given the balance of risks, means the economy Europe. One way or another, I would hope that there is in the best position to withstand whatever shocks will be a resolution of some of the most serious actually occur. problems in the euro area before long. I do not think it is possible to continue indefinitely with this degree Q115 Teresa Pearce: So is a further possible energy of fragility. One way or another, something will price hike in your probability distribution going happen. I would hope that, after that, we will move forward? to a position where we can start to see how it will Sir Mervyn King: Yes, it is. settle down. Q116 Teresa Pearce: There have been a number of Q113 Teresa Pearce: Governor, earlier you were mentions of wages having been flat for quite a long talking about the higher level of inflation and external time, and they might inflate. If wages rise faster than factors such as energy prices, commodity prices and currently forecast, what will happen to inflation, but that a reasonable person would not expect for that to also, with the number of people unemployed, what if be repeated. But, it is my understanding that a that actually depresses wages? How would that affect reasonable person did not expect it in the first place. both of your forecasts? Sir Mervyn King: Absolutely. Sir Mervyn King: These things all interact. If money wages were to rise faster, other things being equal, Q114 Teresa Pearce: Is there anything that the Bank that might actually push unemployment up, which has done to improve its forecasting of such external would then be a dampening factor on wages further events? down. Let me give you one reason why money wages Sir Mervyn King: It is very difficult because many of might rise faster. Let us suppose that, as was these things are inherently unforecastable. We look at mentioned by Mr Love earlier, inflation expectations futures markets, where people buy and sell these were to pick up, so that both employees and instruments in the future. They are the best guess in employers thought that it was sensible to grant a financial markets as to where the prices will go. So higher money wage increase, because they both our forecasts are conditioned not on off-the-wall thought inflation was likely to be higher. That would hopes; they are conditioned on prices in financial lead to a pick-up of inflation itself a little further down markets that we can see for energy and food in the the road. That is one reason why we pay so much future. We take those as our conditioning assumption attention to inflation expectations, because they are for the forecast. There are risks around either side and the conditions—if they rise, they in fact provide the we can look at some of the derivative markets in these conditions in which inflation itself may subsequently energy instruments and see whether the market is pick up. expecting that the risk is more on the upside than the On the other hand, as you point out, if unemployment downside, and we try to take that into account. is to rise further—and we do not know what will It is really very difficult. I have spent 20 years coming happen—that will, other things being equal, be a to this Committee in different forms and saying each dampening factor on wage inflation, provided that the time that forecasts are not spot the ball contests, where level of structural unemployment does not rise at the you know where it is going to be. It is not like that. same rate. It may well do, and that is the one thing All we can do is to assess the balance of risks. The we really want to avoid; having a higher structural only reason we do this—if I did not have to do it, I level of unemployment, which does not dampen wage would never do it and I can assure you that when I inflation, but merely adds to the long-term leave the Bank, I will never make a forecast—is unemployed. These are the challenges we face. because it takes time between when we change our policy instruments and when it affects the economy. Q117 Teresa Pearce: We have seen, I think it is fair That time lag means that we have to look ahead, but to say, a shrinking of the public sector. The public we do so not in terms of pretending that we know sector is often a major purchaser of commodities and what the future holds because no one does. We do it services. Has the committee made any estimation of by looking at the balance of risks. the effect of the decrease of public sector purchasing The judgment we made last year was one where, in power? the event, we were surprised that energy prices moved Sir Mervyn King: Certainly the impact of the upwards much more than we had expected. Who published public spending plans is incorporated into knows what will happen over the next 12 months. The our forecasts, and we take that into account when chances are that energy prices will not move by the projecting levels of demand, output and inflation. exact amount that markets have in their central view, and the chances of that actually happening are close Q118 Teresa Pearce: So it is taken into account. to zero. But, we do not know whether they will be Sir Mervyn King: It is taken into account, yes. surprising on the upside or the downside. That is the difficulty in making forecasts. It is very important for Q119 Teresa Pearce: A final question: we talked policy not to depend on the assumption that it is vital earlier about consumer confidence, and from the to make an accurate forecast in order to make good people who live in my constituency who have no policy judgments. It is important to recognise that no confidence at the moment and are having quiet crises one can make accurate forecasts of an unknowable with their weekly household budgets, if their income cobber Pack: U PL: COE1 [O] Processed: [03-01-2012 12:40] Job: 017636 Unit: PG01 Source: /MILES/PKU/INPUT/017636/017636_o001_th_TC 28 11 11 Corrected.xml

Treasury Committee: Evidence Ev 17

28 November 2011 Sir Mervyn King, Paul Fisher, Dr Ben Broadbent and Dr Martin Weale CBE were to go up, I do not think they would actually but throughout the developed world. In that sense, we spend that increase in income. I believe that they should be very concerned. would try and pay down their debt or save it. Because of all the things, as you have said, that could not be Q122 John Thurso: Is there more in it than that? Is forecast and are not in our recent experience, they are it just an indicator of the fact that we have been afraid to part with their money. Do you think that that deleveraging? is something that is replicated across the country, or Dr Broadbent: I see it more as a contemporaneous is peculiar to my constituency? indicator, if you like, of weakness in the economy, and Sir Mervyn King: No, we spend a great deal of time something that necessarily forecasts nominal growth. in our forecast rounds trying to work out the answer Certainly, if you plot it against the nominal growth to this question. There is no doubt that, given the rate in the economy, that is roughly what you see over uncertainty at present, consumers may well be saying the last few years. That growth rate fell pretty sharply to themselves, “We have a certain amount of debt. We in 2008–09, and it has stuck there, roughly speaking, don’t know what the future holds. Should we build up at zero in the last couple of years. It is a reflection, as a reserve of precautionary savings? It may be very low much as anything else. at present, but perhaps we should have something.” Or will they say to themselves, “Look, consumption has Q123 John Thurso: Would you not have expected fallen so much that if we do see an increase in our real QE to have had an impact? take-home pay this will be an opportunity to increase Dr Broadbent: Well, we talked about it a little earlier. spending somewhat”? Perhaps my colleagues would As Paul Fisher said, I am not sure that one would like to come in on this because we actually spent a lot expect that in an environment in which the banks of the time discussing this question in the forecast remain under pressure—their own funding remains round. under pressure. I do not think it was ever going to be Dr Weale: What I would expect is that you will find the case that the main effect of QE was directly via the different people in different circumstances. There will banking system. Instead, I think it has been operating be some who are keen to reduce their debt but I would largely via the decisions of the non-banks, from whom make the point that although you have seen a asset purchases are made, and what they subsequently reduction in overall household debt, that has come do with the proceeds of gilt sales. I do not think one much more, not because people have been repaying should look at broad money or broad credit growth their debt, but because other people have not been for the effects of QE. borrowing in the way that they used to. There have not, for example, been as many new mortgages as in Q124 John Thurso: The argument has been put to the past. So if you look through that it does not look me that it is something we should be concerned about, as though there has been a rush for people to pay because it indicates that the measures we are taking down their debts. All our experience is that when are not actually working. I wonder if that is an people get an increase in their incomes then different argument that any of you recognise or are prepared to people react in different ways depending on their comment on. circumstances and their situations. But I would be Sir Mervyn King: Let me comment on that, and then very surprised if none of any aggregate increase in perhaps Martin can. To me, the big picture is what income were spent. That would be something that matters here. I think the broad money numbers are a would be extremely unusual relative to past good example of a glass half-full and half-empty. The experience. half-full picture is that, despite the fact that we have had an extraordinarily serious financial crisis, and we are still bang in the middle of it, broad money is still Q120 Chair: Governor, while we are on costs and growing at a positive rate. In the great depression in prices, in chapter 4 of the inflation report, you give the United States, it fell very sharply and led to your best estimate of the effects on the index of the enormous falls in output and employment. We are not falling out of VAT and petrol at 1.5 to 2 percentage in a position where it is falling, and I think that is a points over the next 12 months. However, you do not success of policy. It would have been worse had do a similar calculation for non-energy import policy actions not been taken. If we had not done asset commodity prices. I wonder if you could provide that purchases, broad money would be much weaker than for us. I presume you would want to do it in two it is now. stages: what the value would be as it falls out were The half-empty picture, of course, is that we are still prices stable, and the additional value that could be deep in a financial crisis with weak output, and we are attributed to the recent falls in metals and “softs”. a long way from getting back to normal. When we do, Would you be prepared to provide that to the as Ben says, broad money growth will return to more Committee? normal historical rates. So it is not as high as I would Sir Mervyn King: Yes, of course. wish, but it is a lot higher than one might fear, given what is going on in the world. Q121 John Thurso: Dr Broadbent, how concerned Dr Weale: Could I add to that, please, that I do not should we be at the persistent sluggish growth of see that broad money tells us very much that we did broad money? not know anyway. From my perspective, I think the Dr Broadbent: It is a reflection of the deleveraging— main influence of our asset purchase programme is the shrinkage of the bank’s balance sheets—that has through its influence on long-term interest rates, and driven the recession and the slowdown, not just here then the knock-on effects on other asset prices, on cobber Pack: U PL: COE1 [E] Processed: [03-01-2012 12:40] Job: 017636 Unit: PG01 Source: /MILES/PKU/INPUT/017636/017636_o001_th_TC 28 11 11 Corrected.xml

Ev 18 Treasury Committee: Evidence

28 November 2011 Sir Mervyn King, Paul Fisher, Dr Ben Broadbent and Dr Martin Weale CBE corporate bond rates, on equity prices and so on. in a way that a larger institution would probably be Broad money is simply telling us that the economy is looking for equity? Is part of the problem that as long not terribly lively. as banks are engaged with investment banking it will be so much more profitable across the average year Q125 John Thurso: Governor, can I come back to that they will never pay proper regard to providing the point that you were discussing with George funding for SMEs? Mudie, namely credit to SMEs? We had some of the Sir Mervyn King: As I say, the idea that investment banks in front of us recently, and they gave a picture banking will always be wildly profitable has now of their being out there in the high street, wallets open, gone. It is not at present, and I suspect that there will just waiting for people to come and ask for money. be years when it is and years when it is not. The idea However, every time I meet businesses that are that indefinitely it will be, I think, will go. The real successful in my part of the world, which I do challenge for SMEs is a fundamental problem that any regularly—there are 40 or 50 that I meet regularly, market economy faces: you have got the idea, and I in areas such as manufacturing, engineering and oil have got the money; how do we put the two together? services—they all say that they cannot get money. How can we ensure that I do not put my money at They say either that it is far too expensive or that they unnecessary risk but that you can obtain money for cannot get it at all. The common complaint is that the finance? The banking sector was set up partly to human beings have gone out of the system and they answer that question, but it requires people on the are being judged by a matrix, not a human being. Why ground who can assess not only the merits of the idea is there this complete disconnect between the and the innovation, but the character, personality and commercial world and planet banker? How do we determination of the individual who will take connect that up so that money starts to flow? responsibility for that business and hence the Sir Mervyn King: That is a very big question, which repayments, to decide whether it is worth risking will not be answered easily. It is related to the depositors’ money by lending to that firm. That is proposals of the Vickers commission, which related to something that needs local expertise and support, and trying to ensure that some part of our banking system it is a million miles away from the idea of assessing sees its mission in life—or indeed its passion in life— credit risks in terms of, “Here’s a score list. Please fill as being to serve what I will call ordinary retail in a form and if you get 17 out of 20 you get the household and business customers rather than engage money; if you don’t, you don’t.” You cannot easily do in investment banking transactions. That is a question that for SME lending. of what motivates management and what they really want to do. Q127 John Thurso: It sounds as though you and I There is an enormous contrast between how are saying exactly the same thing, which is that if consumers have benefited from changes in the way there is no human to make a judgment you get bad supermarkets operate, where over 30 years there has decisions, basically. What can the Government do to been a transformation in the retail experience, and the make the banks understand that putting humans back transformation that probably has not happened in the into banking is essential to the future growth of the experience in banking. In part that is because the way economy? banking has gone, around the world, has been Sir Mervyn King: I think that the proposals of the consolidation. The too-big-to-fail problem has meant Vickers commission would go a long way towards that becoming very big was the best route to obtaining creating an environment in which—I suspect that funding at the cheapest possible rate, which meant that market development is pushing us in this direction you could then get an edge on your competitors and anyway—people realise that the merits of putting the become even bigger. That world probably has come two together are a lot less than was thought. Once you to an end now, irrespective of what Governments do. move to a world where investment banking cannot Markets have come to the realisation that they did not guarantee that it can obtain cheap retail deposit understand the risks that were being run in banking. funding guaranteed by Government to finance its What is important, therefore, is gradually to work investment banking balance sheet, it becomes much towards what I would call a new model. It is not more a genuine economic question of whether banks blaming people for what happened; it is the will want to put the two aspects of banking so recognition that the style, nature and culture of closely together. investment banking are very different from what is Chair: Governor, thank you very much for coming required to be a successful retail bank. before us this afternoon. It has been extremely interesting, and we have learned a lot about not only Q126 John Thurso: Do you think it is possible the inflation report, but a number of other topics. actually to get funding for SMEs, which do not Thank you, too, to the other members of the MPC for usually have access to equities—that is a big part of being with us this afternoon. We are very grateful. the problem—and therefore regard their bank finance cobber Pack: U PL: CWE1 [SO] Processed: [12-01-2012 08:33] Job: 017636 Unit: PG02

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Written evidence

Report to the Treasury Select Committee from Sir Mervyn King, Governor of the Bank of England Past Voting Record and the Outlook In the past year the UK economy has experienced an unpleasant combination of high inflation and weak output growth. We have seen a “reluctant” recovery to date because of the headwinds associated with the rebalancing process that is underway at home. But in recent months developments abroad, and especially in the euro area, have increasingly threatened that process of rebalancing and recovery. Over the past year demand has been held back by weak real income growth, tight credit conditions and the fiscal consolidation, despite accommodative monetary policy. Indeed household consumption has fallen back to the level seen in the trough of the recession, and before that at the start of 2005. In the latest data output remains some 4% below its peak, and more than 10% below its pre-crisis trend. The fall in output has surely left a margin of spare capacity in the economy—not least in the labour market, where the unemployment rate had been hovering around 8% for some time, before picking up in the latest data. Over time I would expect this to put downward pressure on inflation. The size of this margin of spare capacity, and its effect on inflation, is however very uncertain. Underlying domestic inflationary pressure has indeed been subdued over the past year, as can be seen in the below-par rate of wage growth. Headline CPI inflation was, however, pushed to above 5% by the contribution of increases in energy prices, import prices and the rate of VAT. We expect inflation to fall back sharply as these price rises drop out of the annual comparison early next year, although the precise timing and extent of the fallback in inflation are uncertain. But as ever it is the outlook for inflation in the medium term that bears on monetary policy. For much of the past year there have been two key risks to that inflation outlook. On the one hand is the risk that a persistent margin of spare capacity and subdued wage growth result in inflation moving below target in the medium term. And on the other hand is the risk that the period of above-target inflation could cause medium-term inflation expectations to drift up, putting persistent upward pressure on inflation. These are the risks that have framed the policy debate over most of the year. Seeking to balance these risks, in each MPC meeting from December last year to September this year I judged that it was appropriate to maintain Bank Rate at 0.5% and the quantity of asset purchases at £200 billion. In recent months, however, events abroad have affected the outlook for the UK economy. The unfolding euro-area crisis and the associated tensions in financial markets and the world economy—working through weaker net trade, higher credit spreads and the likelihood that elevated uncertainty will cause businesses to postpone investment and households to spend less—now threaten the UK recovery. The outlook for output growth in the near term is considerably weaker than even three months ago. Indeed it now seems likely that the level of output will be broadly flat over the next six months. The outlook for inflation in the medium term is correspondingly weaker, and there is a significant risk that it will undershoot the target. In October, in response to this downwards shift in the prospects for the UK economy, the MPC voted unanimously for an additional £75 billion of gilt purchases. This policy seeks to increase the amount of money in the economy. The money received by those selling assets to the Bank can then be used to buy a wide range of other assets, including private-sector securities. In turn, this will raise asset prices and lower the costs of borrowing for private-sector companies, with the aim of boosting overall money spending and ensuring that it grows at a rate that is consistent with meeting the inflation target in the medium term. In taking this action we are treading a fine line between stimulus to demand in the short run and the longer- term need to continue the process of rebalancing and deleveraging. In November I voted to maintain that looser policy stance. In common with every member of the MPC, I stand ready to adjust policy—in either direction—as the balance of risks to the outlook for inflation changes.

Explaining Monetary Policy Over the past year, I have given five on-the-record speeches about the economy and monetary policy. I have answered questions at four Inflation Report press conferences and appeared on four occasions before the Treasury Committee (excluding appearances on non-monetary policy issues). These hearings were all shown on television. I have also appeared on television on a number of other occasions—for example I gave several interviews after the October decision to extend the asset purchase programme. On average I have made a televised appearance about once every three weeks. In addition, I have made eight visits to regions of the United Kingdom outside London—to Northern Ireland, Wales, Scotland, Yorkshire & Humber, the East Midlands, the South-West, the North-West and the North-East of England. These involved numerous company visits and meetings with business people, and have given me a valuable opportunity both to hear the views of those in the business community first hand and to explain the decisions of the MPC. Those visits also gave me a good opportunity to explain our monetary policy actions cobber Pack: U PL: CWE1 [E] Processed: [12-01-2012 08:33] Job: 017636 Unit: PG02

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via interviews with, or articles in, the local press. I have had further opportunities to explain monetary policy in the many informal talks I give, and via frequent meetings with members of the press.

Over the past year, I have also attended more than twenty sets of meetings abroad. Typically these have been meetings of various different international bodies—the G7, G20, IMF, ESRB and BIS. 29 November 2011

Report to the Treasury Select Committee from Paul Fisher, Executive Director for Markets, Bank of England

Voting Record

Since my previous TSC report in July 2010, I have voted with the majority of my MPC colleagues: until October 2011 to keep Bank Rate at 0.5% and to maintain the stock of asset purchases financed by the issuance of central bank reserves at £200 billion. At the October meeting I voted to increase the asset purchase programme by £75 billion.

Following the financial crisis and sharp contraction in output in 2008Ð09, the recovery was always expected to be bumpy. For most of 2010 H2 there were emerging signs that money and earnings growth were starting to pick up from very subdued rates and that the margin of spare capacity in the economy was diminishing, reflecting both growth in demand and an erosion of supply. The risks of medium-term deflation appeared to have diminished with heightened inflation in the short-term reflecting a series of temporary upward shocks to the price level. At the turn of the year there was a case for starting to tighten policy to directly influence the inflation rate in the medium-term and to keep inflationary expectations in check.

But the very weak GDP data for Q4 2010, first published in January 2011, alongside a range of other indicators, suggested that the recovery was not assured. Although the data were affected by the disruptive snowfall in December, I perceived a distinct underlying weakness, particularly in the services sector. As 2011 progressed there was growing evidence to support that assessment. I became increasingly concerned about the profile of consumer spending—which by the time of our March meeting suggested that, at best, there had been no growth in real consumption since mid-2010. That consumption squeeze predated the imposition of the higher VAT rate and much of the planned fiscal consolidation which were both likely to push down further on real household income during 2011. I came to the view that an early tightening in policy would have been at best taking an unnecessary risk and at worst exactly the wrong thing to do. It would have increased the chances of an emerging soft patch becoming entrenched into something longer-lasting, thus threatening the return of deflationary pressures in the medium-term.

Through the summer, those downside risks were compounded by growing evidence of a slowdown in the world economy, renewed strains in a number of financial markets, including the European public markets for unsecured term bank debt (which have been effectively closed since June) and shorter-term US dollar bank funding markets, and by the ongoing sovereign debt crisis in the Euro area. Moreover, there were also signs that domestic spending had continued to slow. There was a growing likelihood of a renewed “credit crunch”. In my view those factors moved the balance of risks to inflation in the medium term decisively to the downside and, as a result, I voted for a £75 billion expansion of the MPC’s programme of asset purchases in October 2011. We may well need to do more. But I see no reason to commit to that now, given that the existing purchases will take until the February MPC meeting to complete.

The Outlook

The outlook for the economy is always uncertain but it is particularly so in such unusual circumstances which include the recovery from a major recession and an ongoing financial crisis including in markets for sovereign debt. Policy needs to focus on the broad picture and the balance of risks. In the absence of further shocks, it seems very likely that inflation will fall back markedly over the next year or so, as the contributions of higher VAT, oil and import prices drop out of the 12 month inflation calculations. In the medium-term, the weak outlook for growth, and the associated amount of slack in the economy, is most likely to cause CPI inflation to fall below the 2% target. But the uncertainty surrounding that judgment is very great, and there are risks in both directions.

For me, the situation in Europe poses the biggest single identifiable risk to the UK growth and inflation outlook. I believe that the absence of a credible, lasting solution has already damaged growth prospects and much of that would persist even if a solution were found. In the near-term, household and business uncertainty are elevated, and likely to remain so. That will affect prospects for consumer spending and domestic investment. A renewed round of commercial bank deleveraging is already underway (particularly on the continent), and is now likely to be hard to reverse. Longer-term, recent developments may also presage structural changes in debt markets. For example, the investor base in bank and some sovereign debt markets may be permanently affected by recent developments, thus having a long-lasting impact on the economy. cobber Pack: U PL: CWE1 [O] Processed: [12-01-2012 08:33] Job: 017636 Unit: PG02

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Explaining Monetary Policy Since I reported to you in July 2010, I have given eight on-the-record speeches/papers. Three of those directly addressed the setting of monetary policy, two discussed markets and financial stability, and the remainder outlined aspects of the Bank’s operations which enable and support both. Facilitated by the Bank’s Agents, I have visited many businesses, participated in roundtable discussions and conducted interviews with local media in Scotland, the North West, the North East, Yorkshire and the Humber, the West Midlands and the South West. I have given interviews in the national press and a substantial number of off-the-record talks and presentations to a wide range of audiences. I have also had hundreds of meetings and phone calls with market participants or their representative bodies to discuss developments in financial markets, as part of the Bank’s market intelligence function, which provides valuable information to both MPC and FPC. That included leading formal structured rounds of visits in London and in New York. I have also regularly represented the Bank in international meetings at the Bank for International Settlements. 29 November 2011

Report to the Treasury Select Committee from Dr Martin Weale, External Member, Monetary Policy Committee, Bank of England Voting Record Between joining the Committee for its meeting in August 2010 and December of the same year, I voted for no change in either asset purchases or in Bank Rate. Late last year, I became increasingly concerned about the rising rate of inflation and the implications of this for the Committee’s ability to deliver its target. In January I therefore voted for a quarter point increase in Bank Rate. A substantial part of the rise in inflation in January of this year was due to the increase in VAT announced in last year’s budget. I felt comfortable with the principle that, because the effect of this would drop out of the inflation rate after about 12 months it would not be appropriate for policy to adjust in direct response to this. There was nevertheless a risk that the resulting increase in prices would have knock-on effects to wage demands; Britain’s past history suggested that this risk was a very real one. Inflation was also elevated because of rising commodity prices and as a result of continuing upward pressure in the aftermath of sterling’s depreciation in 2008 and there was a risk that these influences could also have knock-on effects on wages. There is always considerable uncertainty about the future path of commodity prices and also about the full extent one might expect prices to rise in the aftermath of the depreciation. The Committee has a target for consumer prices and not for domestic costs. This means that it should attempt to offset continuing effects of such influences on the inflation rate. At the same time it does not have an effective means of offsetting the short-term consequences of such movements. There were two factors which lay behind my vote. First of all, the Inflation Reports produced in February and May showed that, if interest rates followed the profile implied by the profile of term interest rates in the money markets, then inflation was expected to be above its target at the two to three year horizon at which the Committee aims to bring the inflation rate to its target. To me, this pointed to a need for a Bank Rate path higher than the market was then expecting. Secondly, even if the market profile had been adequate to bring inflation to target over a two to three year horizon, it seemed to me that there were benefits in increasing Bank Rate earlier rather than later. An earlier tightening would reduce the need for tightening later on. And it would give extra benefits in terms of credibility at a time when the Committee’s reputation was affected by rising inflation. The economy was weaker in the first half of this year than I had hoped, and by the summer my concerns about developments in the euro area had increased. At the same time weakening commodity prices meant that some of sources of inflationary pressure which had worried me were less acute. Putting these factors together and bearing in mind, in particular, the risk of an intensifying financial crisis, I voted for no change in policy in August and September. Had Bank Rate been increased earlier in the year I would have voted to reduce it. By October it was clear that the crisis in the euro area was having more marked effects on activity at home and I therefore joined my colleagues in voting for an additional £75 billion of asset purchases. In November I voted to maintain the asset purchase programme on that scale.

The Outlook for the UK Economy and Inflation The short-term outlook for the economy is that little growth can be expected either in the current quarter or in the first half of next year. Beyond this, while the outlook is as always uncertain, there is no reason to expect growth at rate below the historical trend. In the long term growth may resume at its trend rate or perhaps somewhat faster. The major source of short-term uncertainty the economy faces stems from the continuing crisis in the euro area. It is clear that the current situation cannot continue indefinitely. But there are a number of different ways in which it could be resolved. Some would be highly disruptive to the international economy and others less so. It is possible that the removal of the current uncertainty, following an orderly resolution of the crisis, would be a positive rather than a negative shock to the economy. cobber Pack: U PL: CWE1 [E] Processed: [12-01-2012 08:33] Job: 017636 Unit: PG02

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I mentioned above the inflationary risks which concerned me earlier in the year and it is clear that at least some of these have not materialised. With commodity prices having stabilised and the VAT rate dropping out of the calculation, the rate of inflation must be expected to fall fairly sharply in the first part of next year. Weak economic growth is likely to exert its own additional influence in bringing down inflation. On the face of it there is a strong case for further asset purchases. Increasing the rate at which the Bank makes asset purchases runs the risk of disrupting the smooth running of the gilts market. But if neither economic prospects improve sharply nor inflation prospects worsen, relative to the way they appear at the moment, then I think there will be a strong case for extending the asset purchase scheme when the current purchases of £75 billion have been completed and when it is clear that inflation is falling as we have forecast.

Activities Having voted in a minority in the first half of the year and then changed my vote in August before supporting more asset purchases in October, I have thought it particularly important that I should be prepared to explain my views. Since joining the Committee I have: — Made four public speeches discussing economic circumstances and commenting on structural issues, in one the focus was my thoughts on the presentation of uncertainty. — Undertaken nine regional visits. — Made 34 visits to companies as a part of these. — Talked to 16 business groups. — Given interviews to The Times, Handelsblatt, The Financial Times, Sky News, Radio 4 and Reuters as well as regional newspapers and local radio stations. — Published an article in The Guardian. 29 November 2011

Letter from Sir Mervyn King, Governor of the Bank of England, to the Chairman of the Committee In your letter of 2 November, following our appearance before the Committee on 25 October, you asked for clarification on a number of points relating to the Asset Purchase Facility (APF). In addition you reminded us that we promised to send you a note on commercial bills. This letter responds to those two requests. 1. At the hearing Andrea Leadsom asked about the potential for market movements in the price of gilts to result in losses for the APF. In my response I explained that any profit or loss arising from movements in the market price of gilts held by the APF would be offset by a loss or profit for the Government as issuer of the gilts. You asked for clarification of the mechanism by which the APF’s profit or loss is offset elsewhere in the Government’s accounts, given that the Government’s liabilities are fixed at the point of issuing the securities. As I go on to explain, it is the different accounting treatment of the APF and Government accounts that reconciles these viewpoints. The simple economic logic is that the gilts held in the APF are both an asset and a liability of the public sector. So, taking the public sector as a whole, fluctuations in the market price of the gilts held in the APF have no net impact on the public finances. In practice, however, the gilts in the APF and on the Government’s balance sheet are subject to different accounting conventions. The APF’s assets are “marked to market” so that fluctuations in the market price of gilts affect the APF’s accounts, while the Government’s liabilities are not. But the use of different accounting conventions does not alter the underlying economic logic. Although you correctly observe that the face value of the Government’s liabilities are fixed when the securities are issued, it is the present value of the resources needed to service those liabilities that matters economically, and that does vary. A simple thought experiment makes these arguments clear. Suppose the market price of the gilts in the APF were to fall because of a rise in the prevailing risk-free interest rate, so that the APF incurred a loss on its gilt holdings. Those same gilts are liabilities of the Government, and are accounted for at face value in the Government’s accounts. The Government could, however, choose to issue new gilts with a lower face value (matching the market value of the gilts held by the APF), and use the revenue raised to repurchase the gilts in the APF, and then retire them. That would reduce the overall face value of its outstanding liabilities, allowing the Government to book a gain matching the APF’s losses on its gilt holdings. In economic terms nothing would be gained (or lost) from this reshuffling of liabilities, since the present value of the Government’s liabilities is unaffected by the exercise. Yet the face value of its liabilities would be lower afterwards. The outcome in an accounting sense would be the same as if it had marked its liabilities to market. The important point of economic substance is that such a fall in the market value of the gilts in the APF is matched by a fall in the current resources required to service the Government’s future liabilities. Those two effects offset, and that is the sense in which the public sector can be unaffected by movements in the market value of gilts in the APF. cobber Pack: U PL: CWE1 [O] Processed: [12-01-2012 08:33] Job: 017636 Unit: PG02

Treasury Committee: Evidence Ev 23

More generally, I am strongly of the view that the APF accounts do not provide a meaningful guide to the overall impact of asset purchases on the public finances. Monetary policy, however it is implemented, affects the market value of existing debt, whether on the balance sheet of the private sector, the central bank or the remainder of the public sector. It also has implications for the cost of issuing new debt. And it affects macro- economic conditions, including the level of output and inflation, and thereby both taxation and spending. Any overall assessment of the impact of the MPC’s asset purchases on the public finances would therefore have to take into account the improvement in the Government’s financing costs, as well as the higher fiscal revenues and lower expenditures arising from the boost given to economic activity by asset purchases. In short, such an exercise would have to compare what actually happened to a hypothetical set of circumstances in which an alternative policy was followed. That is not what the APF accounts are designed to capture. Charles Bean’s speech on 13 October 2009 provides further explanation of this issue.1 I continue to believe, however, that this type of financial assessment is not the appropriate basis on which to judge the success of monetary policy. We do not usually seek to isolate or evaluate the effect of monetary policy in these terms, by calculating the counterfactual profit or loss to the public finances. The judgement about the success or failure of asset purchases rests instead on their contribution to achieving the overall aims of monetary policy—exactly the same criterion on which we evaluate interest rate decisions. 2. You ask also for further information about why the Bank stopped purchasing high-quality commercial bills—also sometimes known as “bankers” acceptances’—as part of our sterling monetary framework. A useful discussion of the background is given in a short box published in the Bank’s Winter 2005 Quarterly Bulletin at the time when these bills were made ineligible for the Bank’s open market operations. In summary, the Bank ceased to accept commercial bills from 17 August 2005, largely because the size of the market had fallen to around only £1 billion. It had been evident for some time before then that the market for commercial bills continued to exist only because of the eligibility of such bills in the Bank’s own operations. As the box explains, official operations in such a small market were at times problematic; partly for that reason, the Bank encouraged the development of a gilt repo market, which it began using in its own operations from Spring 1997. As gilt repo developed into a much larger, more homogeneous and hence more liquid market than that for commercial bills—the market for commercial bills contracted further, to the point where the Bank judged that eligibility should be removed. In early 2009, the Bank considered potential ways of improving the availability of working capital finance for those firms which did not have access to modern corporate bond or commercial paper markets. This work, which included discussions with commercial bank treasurers and others, concluded that there was little evidence to suggest that renewed acceptance of commercial bills in the Bank’s operations would successfully catalyse private markets. One reason for this was that banks said they would be less willing to trade bills in a secondary market than they had been in the 1980s and 1990s. That in turn reflected three main factors. First, such bills are individually small in size. Second, bills accepted by another bank count against counterparty exposure limits, which have been tightened since the financial crisis. And, third, commercial bills count as unsecured lending and attract the same capital charge, so any market making activity in bills might reduce capacity to lend directly to businesses. In summary, it is clear that the market for commercial bills came to a natural end. In view of the factors underpinning that demise, I judge it unlikely that a significant private sector market for this particular form of asset will re-emerge in the future. As I said at the hearing, it would be inappropriate, indeed almost certainly futile, for the Bank to try to revive a market for which there appears no latent demand. Hitherto, other official sector efforts to support the provision of credit to SMEs through the issuance of tradable securities have also proved difficult. For example the Bank’s Secured Commercial Paper Facility (SCPF), launched in July 2009, enables suppliers, which include many small and medium-sized companies, to have their invoices paid early (at a discount) rather than waiting for payment from their investment-grade corporate customers under their normal payment terms. The funding is provided by a commercial bank in return for the supplier’s invoice. The commercial bank can then choose to retain these trade receivables or sell an interest in them to other investors, such as via the SCP programme. The scheme has, however, received limited take-up to date. For these reasons, I have continued to advocate policies that would, instead, create incentives for banks to lend to SMEs through their existing infrastructure. I expect the Chancellor will have more to say on this in his Autumn Statement on 29 November. 24 November 2011

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1 The speech is available on the Bank’s website at http://bankofengland.co.uk/publications/speeches/2009/speech405.pdf